SARANSH

Last Mile Referencer for

The Institute of Chartered Accountants of India Board of Studies

(Set up by an Act of Parliament)

INTERMEDIATE
GROUP-II
PAPER 4

COST AND
MANAGEMENT
ACCOUNTING

www.icai.org I https://boslive.icai.org
 Saransh -
Last Mile Referencer for
Cost and Management
Accounting

While due care has been taken in preparing this booklet, if any errors or omissions are noticed, the same may be
brought to the notice of the HoD, BoS. The Council of the Institute is not responsible in any way for the correctness
or otherwise of the matter published herein.

© 2024. The Institute of Chartered Accountants of India (Also referred to as ICAI)

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted,
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permission, in writing, from the publisher.

Published in May 2024 by:

Board of Studies
The Institute of Chartered Accountants of India
‘‘ICAI Bhawan” A-29, Sector-62,
Noida 201 309

©ICAI B O S
 Board of Studies, the student wing of the Institute, does not leave any stone
PREFACE

unturned in providing best-in-class services to its students. It imparts quality

academic education through its value-added study materials, wherein
concepts are explained in lucid language. Illustrations and Test-Your-Knowledge
Questions contained therein facilitate enhanced understanding and application
of concepts learnt. Website for practising MCQs & Case Scenarios contain a
rich bank of MCQs and Case Scenarios to hone the analytical skills of students,
by applying the concepts learnt in problem solving. Revision Test Papers
contain updates and Q & A to help students update themselves with the latest
developments before each examination and revise the concepts and provisions
by solving questions contained therein. Suggested Answers containing the ideal
manner of answering questions set at examination also help students to revise
for the forthcoming examination. Mock Test Papers help students to assess their
level of preparedness before each examination. BoS also conducts live virtual
classes through eminent faculty for its students across the length and breadth
of the country.

To reach out to its students, the BoS has also been publishing subject-specific
capsules in its monthly Students’ Journal “The Chartered Accountant Student”
since the year 2017 for facilitating effective revision of concepts dealt with in
different topics of each subject at the Foundation, Intermediate and Final levels
of the chartered accountancy course. Each issue of the journal includes a
capsule relating to specific topic(s) in one subject at each of the three levels. In
these capsules, the concepts and provisions are presented in attractive colours
in the form of tables, diagrams and flow charts for facilitating easy retention and
quick revision of topics.

In today’s business world, Chartered Accountants are very much part of the
decision-making team of any Organisation. They are rigorously involved in
decision making process with the help of Cost and Management Accounting
tools. The saransh on Intermediate Paper 4 ‘Cost and Management Accounting’
covers diagrams, flow charts tables and formulas. In addition, it encompasses
case studies and skill assessment-based questions so that students can
critically analyse business problems and strengthen their analytical skills
through interpreting and evaluating. This saransh, though, facilitates the
students in undergoing quick revision, under no circumstances, such revisions
can substitute the detailed study of the materials provided by BoS.

Happy Reading

©I CAI BOS
S ARANSH

President Message

It is with immense pride that I introduce the Saransh booklets, a meticulously

curated resource available across the Foundation, Intermediate, and Final
levels of the Chartered Accountancy course. ICAI has always been dedicated
to providing our students with the best possible resources to succeed in their
studies and careers, and Saransh is a demonstration of this commitment.

The Saransh — Last Mile Referencers have been thoughtfully designed by the
Board of Studies (BoS) to serve as an invaluable companion for your studies
and exam preparation. Our aim is to simplify complex concepts and provisions,
making them easier to understand, memorize, and revise. However, Saransh is
not a substitute for the detailed BoS study material but a supplementary tool to
complement your in-depth study.

The newly revamped Saransh booklets have been updated not only in content
but also in their presentation. With a more logical and organized structure,
enhanced visual appeal, and a user-friendly layout, these booklets are now
more effective in aiding your studies.

We have extended the Saransh series to cover all core areas of the Chartered
Accountancy course. Whether you are studying Direct Tax Laws and International
Taxation, Indirect Tax Laws, Accounting Standards, Indian Accounting Standards,
Auditing, Cost and Management Accounting, Strategic Cost Management and
Performance Evaluation, Company Law, or Financial Management and Strategic
Management, you will find a Saransh booklet for each subject.

Saransh is designed not only to help you grasp and recall essential concepts
but also to guide you in approaching each subject strategically. The insights
provided in these booklets will help you develop a structured approach to your
studies, ensuring that you are well-prepared for your examinations.

I urge you to make the most of the Saransh booklets. While these booklets will
support you, it is your dedication, perseverance, and hard work that will ultimately
determine your success.

I wish each of you the very best in your studies and future careers.

Warm regards,

CA. Ranjeet Kumar Agarwal
President, ICAI

©ICAI B O S
 The Institute of Chartered
Accountants of India
(Set up by an Act of Parliament)

Board of Studies

INDEX
Chapters Pg No.

Introduction to Cost and Management Accounting 01

Material Cost 10

Employee Cost and Direct Expenses 17

Overheads: Absorption Costing Method 31

Activity Based Costing

37

Cost Sheet 46

Cost Accounting Systems 53

Unit & Batch Costing 58

Job Costing 63

Process & Operation Costing 69

Joint Products & By Products 73

Service Costing 81

Standard Costing 92

Marginal Costing 98

Budget and Budgetary Control 109

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In today’s cutthroat competitive landscape, Cost and Management Accounting is no

Before We Begin longer just a tool for internal reporting but a strategic process. It empowers businesses to
reduce costs, optimize pricing, and improve operational efficiency, ensuring they stay
ahead of the competition while maintaining profitability and long-term sustainability.
Without a clear understanding of costs, businesses may lose their competitive edge and
profitability. This subject serves as the backbone of financial planning, providing insights
into both current performance and future financial prospects. It helps managers and
business leaders in decision-making, planning, and control by providing relevant cost-
related information.
Chartered Accountants, acting as a worldwide business solution provider, have a crucial
role in assisting a company to achieve its long-term objectives. Cost and Management
Accounting assists Chartered Accountants in making prompt and knowledgeable business
decisions.
The objective of this subject is to develop an understanding of the basic concepts and
applications to establish the cost associated with the production of products and provision
of services and apply the same to determine prices, understanding of cost accounting
statements and to acquire the ability to apply information for cost ascertainment, planning,
control and decision making.
Some Tips on How to Prepare for the Examination
When it comes to studying for practical exams, memorizing key concepts and information
is essential. To improve your memorization abilities, consider incorporating the following
techniques into your study routine:
Repetition and Practice
Regularly reviewing and practicing cost concepts strengthens your understanding and
helps you retain the information. Practice problem solving to ensure you understand the
concepts. Working through material repeatedly strengthens your memory, making it more
likely you will retain the information in time for the exam. Using these effective memory
techniques will help you improve your ability to remember concepts you have learned and
apply them during the exam.
Use Flashcards and Note-Taking
Use flashcards to enhance your reminiscence of key concepts, formulas, and definitions.
Write down the data you want to memorize on one facet of the flashcard and the
corresponding info on the opposite facet. Test yourself often with the aid of using he
flashcards and actively recalling the data. This method support your reminiscence via
repetition and lively engagement. In addition, take complete notes in the course of your
study sessions. Summarize essential points, spotlight key terms, and prepare data in a
manner that makes feel to you. The act of writing down data can aid in retention, and
reviewing your notes often allows strengthen your understanding. Nothing compares to
handwritten notes when you want to master the 3 Rs of memory: remember, retain, and
recall. The extra you write, the higher you understand. The extra you study the notes on your
very own handwriting, it complements your mind’s ability to seize data and preserve it for
an extended period.
Mnemonic Devices / ACRONYMS
Mnemonic devices are memory aids that help you remember information by associating
it with something easier to recall. For example, you can create an acronym using the first
letter of each term you need to remember. This technique can be particularly helpful when
memorizing theory or formulas.
Time Management
One important thing to be kept in mind is Time Management specially during the Exam.
Always allocate specific time to each section and stick to it. For this you can practice model
test papers so that you can approach the exam with clarity and improve your chances of
achieving a high score.
Visualizations and Imagery
Visualizing information can improve memory retention. Create mental images or diagrams
to represent complex cost concepts. Charts, graphs and tables can be excellent tools,
especially for taking notes on practical subjects such as cost and management accounting
and financial management. This is a good way to take notes on formula etc. Connecting
visual images to content makes it easier to remember during exams.

©ICAI B O S
 SA R AN S H

Cost and Management Accounting

In contemporary business environment, existence of an entity depends on the way it tackles the challenges posed
by the competitive market conditions. Cost leadership being one of the competitive strategies, gives an added
advantage to the entity. Cost being an important aspect for survival and growth in business, requires a mandatory
awareness about the cost control and cost reduction. Fourth industrial revolution, also known as Industry 4.0, puts
more emphasis on the digitization of information for effective decisionmaking, which enables an entity in keeping
ahead of competition. Cost and Management accounting, a discipline of accounting, capacitates an entity in
taking timely decisions by provisions of cost, profitability and other relevant information.

Chartered Accountants, as a global business solution provider, play an important role in business, have an onus
by helping an entity to achieve its long-term objectives. In this direction, Cost and Management Accounting helps
Chartered Accountants in taking timely and informed business decisions.

Introduction to Cost and Management Accounting

Chapter Overview

Objectives of Cost
and Management
Accounting Scope of Cost
and Management
Accounting Role & Functions of
Cost and Management
Accounting Users of Cost
and Management
Accounting

Relationship of Cost
and Management
Accounting with other
Cost Accounting accounting disciplines
using IT
Cost Object

Responsibility
Centres
Cost
Classification

Meaning of Terms used in Cost and Management Accounting

First of all, let us discuss the meaning of various terminologies used in Cost and Management Accounting to have a
clear understanding about the subject.

Cost Costing Cost Cost Accountancy Management Cost Management

The amount Costing is Accounting Accounting
Cost Accountancy It is an application of
of expenditure defined as the It is the has been defined as Management management
incurred on or technique and process of the application accounting is accounting concepts,
attributable to a process of accounting for of costing and the application methods of collections,
specified article, ascertaining cost. cost accounting of the principles analysis and
product or costs. principles, of accounting presentation of
activity. methods and and financial data.
techniques. management.

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Introduction

Objectives of Cost Accounting

There are many objectives of cost accounting. The main objectives are explained below. We also need to keep our
focus on understanding the difference between Cost Control and Cost Reduction.

Assisting management
Ascertainment of Cost: The Objectives in decision making:
main objective of cost and Cost and Management
management accounting of Cost accounting by providing
is accumulation and
ascertainment of cost. Costs
Accounting relevant information, assists
management in planning,
are accumulated, assigned implementing, measuring,
and ascertained for each controlling and evaluation of
cost object. various activities.

Cost Reduction: It may be defined “as

Determination of Selling Price the achievement of real and permanent
and Profitability: The cost reduction in the unit cost of goods
and management accounting manufactured or services rendered
system helps in determination of without impairing their suitability for the
selling price and thus profitability use intended or diminution in the quality
of a cost object. of the product.”

Cost Control: Maintaining discipline in expenditure is one of the main

objectives of a good cost and management accounting system. It
ensures that expenditures are in consonance with predetermined set
standard and any variation from these set standards is noted and
reported on continuous basis.

Scope of Cost Accounting

We also need to know various scopes of cost accounting. Cost ascertainment and the process of cost accounting are
the major scopes. The other scopes are presented below:

Scope of Cost Accounting

Cost Cost Cost Statutory

Cost Analysis Comparisons Control Reports Compliances

2 ©ICAI B O S
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Introduction

Role and Functions of Cost and Management Accounting

Role of a Cost and Management Functions of Cost and

Accounting system Management Accounting System

Provide Collection and

relevant accumulation
information to of cost for
management each element
for decision of cost
making

Assigning costs
to cost
Assist objects to
management ascertain cost.
for
planning,
measurement,
evaluation and
controlling of
business Sets budget and
activities standards
for a particular
period
or activity
beforehand
and these are
Help in compared
allocation of with the assigned
cost and
to products ascertained cost.
and inventories
for both
external and
internal users. Provision of
relevant
information to
the
management
for decision
making.

To gather data
like time
taken,
wastages,
process
idleness etc.,
analyse the
data, prepare
reports and
take necessary
actions

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Introduction

Users of Cost and Management Accounting

Cost and Management Accounting information which are generated or collected are used by various stakeholders.
The users of the information can be broadly categorized as below:

Regulatory
Authorities
Managers

Auditors
External
Internal Operational Users
level staffs
Users

Shareholders

Employees
Creditors and
Lenders

Relationship of Cost Accounting, Management Accounting, Financial

Accounting and Financial Management
There is a close relationship between various disciplines like Cost Accounting, Management Accounting, Financial
Accounting and Financial Management. Sometimes these disciplines are interrelated and dependent on each
other also.

Cost
Management Accounting
Accounting

Financial
Accounting

Financial Management

4 ©ICAI B O S
 SA R AN S H
Introduction

Essentials of a good Cost Accounting System

The essential features which a cost accounting system should possess are depicted as below:

Informative Accurate and Uniformity and Integrated Flexible and Trust on the
and simple authentic consistency and inclusive adaptive system

Cost Accounting using Information Technology

With the use of information technology, the cost accounting system gets integrated and automated. The basic features
are depicted as below:

Enterprise Resource Internet (including intranet

Planning (ERP) and extranet)

Cost Accounting
using IT

Paperless Environment Just-in-Time (JIT)

Cost Objects
It is very important to understand the meaning of cost object, cost unit and cost driver. Their meaning alongwith
examples are illustrated below:

Cost Object: Cost object is anything for which

a separate measurement of cost is required. Cost
object may be a product (book), a service (airline),
a project, a customer, a brand category etc.

Cost Units: It is a unit of Cost Drivers: A Cost driver

product, service or time (or is a factor or variable which
combination of these) in effect level of cost. Example
relation to which costs may for a purchase department is
be ascertained or expressed. number of purchase orders.
Example for power industry is
kilo Watt hour (kWh).

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Introduction

Responsibility Centres
To have a better control over the organisation, management delegates its responsibilities and authorities to various
departments or persons, which are known as responsibility centres. There are four types of responsibility centres as
discussed below:

Responsibility Centres

Cost Centres: Profit Centres: Investment Centres:

Revenue Centres:
the responsibility Which have both Which are not only
Which are
centre responsibility of responsible for
accountable for
which is held generation profitability
generation of
accountable of revenue and but also have the
revenue for
for incurrence of incurrence authority
the entity.
costs of expenditures. to make capital
Example- Sales
which are under Example- investment
Department.
its control. Decentralised decisions. Example-
branches of Maharatna, Navratna
an organisation. and Miniratna.

Standard Cost Discretionary

Centre: Cost
Cost Centre Centre:
where output The cost centre
is measurable whose
and input output cannot be
required for the measured
output can in financial terms.
be specified.

Classification of Costs
Classification of costs basically means grouping of costs according to their common features. The important ways of
classification of costs are illustrated as below:

By Nature
By Controllability
or Element

Classification By Normality
By Functions
of Costs

By Costs for
By Variability Managerial
or Behaviour Decision Making

6 ©ICAI B O S
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Introduction

(i) By Nature or Element

Elements Of Cost

Material Cost Labour Cost Other Expenses

Direct Indirect
Direct Indirect Direct Indirect
Material Material
Labour Cost Labour Cost Expenses Expenses
Cost Cost

Overheads

Selling and
Production Administration
Distribution
Overheads Overheads
Overheads

(ii) By Functions

}
Direct Materials
Direct Employees (Labours) Prime Cost
Direct Expenses
Indirect Material Factory Overheads Factory Cost or Works Cost

Indirect Labour

Indirect Expenses } Administration Overheads

Selling and Distribution

Overheads
Cost of Goods Sold

Cost of Sales

(iii) By Variability or Behaviour

Fixed Cost Variable Cost Semi-variable Cost

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Introduction

(iv) By Controllability

Controllable Costs: Cost that can be controlled

Uncontrollable Costs: Costs which cannot be influenced

or controlled

(v) By Normality

Normal Cost - It is the cost which is normally incurred

Abnormal Cost - It is the cost which is not normally

incurred

8 ©ICAI B O S
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Introduction

(vi) By Cost for Managerial Decision Making

(a) Pre A cost which is computed in (j)

It is that portion of total cost, which
determined advance before production or Out-of
involves cash outflow
Cost operations start pocket Cost

A pre-determined cost, which is

Those costs, which continue to
(b) calculated from managements (k)
be incurred even when a plant is
Standard ‘expected standard of efficient Shut down
temporarily shut-down e.g. rent,
Cost operation’ and the relevant Costs
necessary expenditure rates, depreciation, etc

The amount at any given volume of

Historical costs incurred in the past
(c) output by which aggregate costs
Marginal are changed if the volume of output (l) are known as sunk costs. They play
Cost is increased or decreased by Sunk Costs no role in decision making in the
one unit current period.

The expected cost of manufacture,

or acquisition, often in terms of a
(d) unit of product computed on the (m) These costs refer to the cost of
Estimated basis of information available in Absolute any product, process or unit in its
Cost advance of actual production or Cost totality.
purchase

(n) Such costs are not tied to a clear

It represents the change (increase
Discretionary cause and effect relationship
(e) or decrease) in total cost (variable
Costs between inputs and outputs.
Differential as well as fixed) due to change in
Cost activity level, technology, process or
method of production, etc. These are the costs, which are not
assigned to the products but are
(o)
charged as expenses against the
Period Costs
revenue of the period in which
(f) These costs are notional costs
they are incurred.
Imputed which do not involve any cash
Costs outlay.
These are costs that result
(p)
specifically from a clear cause and
Engineered
effect relationship between inputs
(g) These are costs which are Costs
and outputs.
Capitalised initially recorded as assets and
Costs subsequently treated as expenses.
These costs are also known as out
of pocket costs and refer to costs
(q)
These are the costs which are involving immediate payment of
(h) Explicit
associated with the purchase and cash. Salaries, wages, postage and
Product Costs
sale of goods (in the case of telegram, printing and stationery,
Costs interest on loan etc.
merchandise inventory).

is cost refers to the value of

(i) sacrifice made or benefit of (r)
These costs do not involve any
Opportunity opportunity foregone in accepting Implicit
immediate cash payment.
Cost an alterna tive course of action. Costs

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Material Cost
Chapter Overview

Material Procurement: Valuation of Materials Material Storage & Record

• Bill of Materials Received • Bin Cards
• Material Requisition Note • Stores Ledger
• Purchase Requisition • Stock Control Cards etc.
• Goods Received Note
• Material Returned Note etc.

Inventory Control: Valuation of Material Issues: Accounting & Control of:

• Setting of various stock levels • Cost Price methods (FIFO, • Waste, Scrap, Spoilage,
• Economic Order Quantity LIFO. etc) Defectives etc.
(EOQ) • Average Price methods
• Techniques of Inventory • Market Price methods
Control etc. • Notional Price methods

Consumption of Materials

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Material Cost

Value at Which Materials are Recorded in Stores Ledger

From the following table we can understand the procedure of calculating total value at which materials are to be
recorded in stores ledger.

Particulars Amount Amount

Purchase Price XXX
Additions/ Inclusions:
Insurance charges XXX
Commission or brokerage XXX
Freight inward XXX
Cost of containers XXX
Wastage due to normal reasons XXX
Duties and Taxes for which no credit or refund is available XXX XXX
Deduction/Exclusions:
Discount, Rebate and Subsidy XXX
Duties and Taxes for which credit or refund is available XXX
Penalties and charges XXX
Other expenses not borne XXX (XXX)
XXX

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Material Cost

How Material is Procured?

Material requirement procedure can be understood with the help of the following diagram. We should focus on various
documents in general required and also should keep in mind the departments who initiate these documents.

Bill Of Materials- it is the basic document Material Requisition Note - It is

which is prepared by experts specifying prepared by the department which
the quality and quantity of materials require materials for processing.
required to make final goods.

Purchase Requisition Note- It is the

Purchase Order- After selection of document which authorise purchase
vendor for the materials, the purchase department to purchase the requisitioned
department initiates purchase order for materials. Based on this document the
the required quality and quantity. purchase department invites proposals or
quotations from the vendors

Good Recieved Note (GRN)- This Material Returned Note - This document
document is evidence of the receipt of is prepared when all or any materials are
goods from the vendors. returned back to vendor.

Invoice - this is the bill charged by the

vendor for the materials. Invoice also
shows the duties and taxes to be paid for
the purchase of materials. The invoice is
the basis for valuation of material in store
ledger and book of account.

How Inventory is Controlled?

Inventory control is the function of ensuring that sufficient inventory is retained to meet all requirements. In inventory
control, it is essential to balance between overstock and understock. Various techniques of inventory control are
illustrated below:

Inventory control

By Setting On The Basis Of

Using Ratio Analysis Physical Control
Quantitative Levels Relative Classification

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Material Cost

(a) Inventory Control- By Setting Quantitative Levels

Re-order Stock Level When to Order

Re-order Quantiy/ EOQ How Much to Order

Maximum Stock Level Upto How much to stock

Minimum Stock Level Atleast How much to keep

Average Stock Level Stock normally kept

Danger Stock Level Kept for emergency requirement

Buffer Stock To meet sudden demand

(i) Re-order Stock Level (ROL): Maximum Consumption × Maximum Re-order Period Or, ROL = Minimum Stock Level +
(Average Rate of Consumption × Average Re-order period)

(ii) Re-Order Quantity/ Economic Order Quantity (EOQ):

2x Annual Requirement (A) x Cost per order (O)

EOQ =
Carrying Cost per unit per annum (C)

Just in Time (JIT) Inventory Management

JIT is a system of inventory management with an approach to have a zero inventories in stores. According to this
approach material should only be purchased when it is actually required for production.

Production Material
Demand starts to Requirement Order for raw Supplier sent the
for final process the is sent to materials sent to material for
product demad for Purchase supplier production
product department

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Material Cost
(iii) Minimum Stock Level:
Minimum Stock Level = Re-order Stock Level - (Average Consumption Rate × Average Re-order Period)

(iv) Maximum Stock Level:

Maximum Stock Level = Re-order Level + Reorder Quantity - (Minimum Consumption Rate × Minimum Re-order
Period)

(v) Average Inventory Level:

Average Stock Level = Minimum Stock Level
+ 1/2 Re-order Quantity
Or Maximum Stock Level + Minimum Stock Level
Average Stock Level =
2

(b) On the basis of Relative Classification

On the basis of value and

ABC Analysis
frequency of inventory

Fast, Slow and Non Moving (FSN) On the basis of inventory

turnover

Vital, Essential and Desirable (VED) On the basis of importance

of inventory

On the basis of price of an

High, Medium and Low (HML)
item of inventory

(c) Using Ratio Analysis

(i) Input Output Ratio: Input-output ratio is the ratio of the quantity of input of material to production and the standard
material content of the actual output.

(ii) Inventory Turnover Ratio:

Cost of materials consumed during the period
Inventory Turnover Ratio =
Cost of average stock held during the period

(d) Physical Control

(i) Two Bin System: Two Bin System is supplemental to the record of respective quantities on the bin card and the
stores ledger card.

(ii) Establishment of system of budgets: Based on this, inventories requirement budget can be prepared. Such a
budget will discourage the unnecessary investment in inventories.

(iii) Perpetual inventory records and continuous stock verification : Perpetual inventory represents a system of
records maintained by the stores department in the form of Bin cards and Stores ledger.

(iv) Continuous Stock Verification: The system of continuous stock-taking consists of physical verification of items
of inventory.

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Material Cost

Valuation of Material Issue

Cost Price Methods Average Price Methods Market Price Methods Notional Price Methods
• Specific Price • Simple Average • Replacement • Standard Price
Method Price Method Price Method Method
• First-in First-out • Weighted Average • Realisable Price • Inflated Price
(FIFO) method Price Method Method Method
• Last-in-First-out • Re-use Price
(LIFO) method Method
• Base Stock
Method

Some of the techniques are discussed as follows:

(i) First-in First-out method (FIFO): The materials received first are to be issued first when material requisition is
received. Materials left as closing stock will be at the price of latest purchases.

(ii) Last-in First-out method (LIFO): The materials purchased last are to be issued first when material requisition is
received. Closing stock is valued at the oldest stock price. (Accounting Standard- 2 and Ind AS-2 do not allow LIFO
method for inventory valuation, however, for academic knowledge it may be studied)
(iii) Simple Average Method:

Total of unit price of each purchase

Material Issue Price= Total Nos of Purchases

(iv) Weighted Average Price Method: This method gives due weightage to quantities purchased and the purchase
price to determine the issue price.

Total cost of materials in stock

Weighted Average Price =
Total quantity of materials

Normal and Abnormal Loss of Materials

Loss of Material

Waste: Portion Scrap: The Spoilage: Goods Defectives: Obsolescence:

of basic raw incidental material damaged Goods which It is the loss in
material lost in residue coming beyond can be rectified the intrinsic
processing out of certain rectification to and value of an
having no manufacturing be sold without turned out as asset due to its
recoverable operations further good units by suppression.
value. having low processing. the application
recoverable value. of additional
labour or other
services.

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Material Cost

Treatment of Loss of Material

(i) Treatment of Waste
Normal- Cost of normal waste is absorbed by good production units.

Abnormal- The cost of abnormal loss is transferred to Costing Profit and loss account.

(ii) Treatment of Scrap

Normal- The cost of scrap is borne by good units and income arises on account realisable value is deducted
from the cost.

Abnormal- The scrap account should be charged with full cost. The credit is given to the job or process
concerned. The profit or loss in the scrap account, on realisation, will be transferred to the Costing Profit and Loss
Account.

(iii)Treatment of Spoilage
Normal- Normal spoilage (i-e., which is inherent in the operation) costs are included in costs either charging the
loss due to spoilage to the production order or by charging it to production overhead so that it is spread over all
products.

Abnormal- The cost of abnormal spoilage (ie., arising out of causes not inherent in manufacturing process) is
charged to the Costing Profit and Loss Account.

(iv)Treatment of Defectives:
Normal- The cost less realisable value on sale of defectives are charged to material cost of good production.

Abnormal- The material cost of abnormal loss is transferred to costing profit and loss account.

(v) Treatment of Obsolescence: The value of the obsolete material held in stock is a total loss and immediate
steps should be taken to dispose it off at the best available price. The loss arising out of obsolete materials on
abnormal loss does not form part of the cost of manufacture.

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Employee Cost and Direct Expenses

Points of Discussion

Meaning of Control of
Employee Employee Employee
(Labour) Cost Cost Overtime Idle Time (Labour)
Turnover

Wage and Efficiency

Attendance Absorption of
Incentives Wages Rating
& Payroll
Payment Procedures
Procedures
System

Meaning of Employee (Labour) Cost

• Benefits paid or payable to the employees of an entity,

whether permanent, or temporary for the services
Employee (Labour) Cost rendered by them.

• Includes payments made in cash or kind.

Employee cost includes

Allowances Payment
Wages and
and for
salary
incentives overtimes

Employer’s Other benefits

contribution (leave with pay,
to PF and other free or subsidised
welfare food, leave travel
funds; concession etc.)

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Employee Cost and Direct Expenses

Classification of Employee cost:

Direct
employee cost
Indirect
employee cost

Direct employee cost Indirect employee cost

1. Cost of employees, directly engaged in the production 1. Cost of employees who are not directly engaged in the
process. production process.
2. Easily identifiable and allocable to cost unit. 2. Apportioned on some appropriate basis.

3. Varies with the volume of production and has positive 3. May not vary with the volume of production.
relationship with the volume.

Employee Cost Control

• To control over the cost incurred on employees.

Employee (Labour) • To keep the wages per unit of output as low as possible.
Cost Control
• To give the employees an appropriate compensation and
encourage efficiency.

Factors for the Control of Employee Cost:

Control over timekeeping

Assessment of manpower requirements.
and time booking.

Control over idle time

Time and Motion Study.
and overtime.

Control over employee turnover. Wage and Incentive systems.

Job Evaluation and Merit Rating. Employee productivity.

18 ©ICAI B O S
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Employee Cost and Direct Expenses
Time-keeping: A record of total time spent by the employees in a factory.

Objectives of Time Keeping:

For the preparation

(i) of payrolls.

For calculating
overtime. (ii)

For ascertaining
(iii) employee cost.

For controlling
employee cost. (iv)

For ascertaining
(v) idle time.

For disciplinary
purposes. (vi)

For overhead
(vii) distribution.

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Employee Cost and Direct Expenses

Methods of Time-keeping

Methods of Time-keeping

Manual Methods Mechanical/Automated

Methods

Attendance Punch Card Biometric

Register method Metal Disc / Token method Attendance Attendance system

Time-Booking: A method wherein each activity of an employee is recorded.

Objectives of Time Booking

To compute the
(i) cost of the job
or activity.

To measure
efficiency. (ii)

To analyse the variance in

(iii) time with respect to the
standard time.

For collection of all such data, a separate record,

generally known as Time (or Job) card, is kept.

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Employee Cost and Direct Expenses

Payroll Procedures of Employees

Time-keeping Personnel/ HR
Department Department

2. Employee
Payroll
Attendance
1. Time and

Department

Details
3. Wage and
Salary sheet

5. Deposit of deductions
and contributions
Cost/Accounting
Department

4. Payment after deductions

and contributions

Employees Statutory Bodies

Step
1
• Attendance and Time details:
Detailed sheet of number of days or hours worked by each employee as reflected by the time
keeping methods are sent to the payroll department.

Step
2
• List of employees and other details:
List of employees on roll and the rate at which they will be paid is sent by the personnel/
HR department.

Step
3
• Computation of wages and other incentives:
Payroll department prepares pay slip and forward the same to the cost/ accounting department.

Step
4
• Payment to the employees:
After all deductions (like PF, ESI, TDS), wages/salary is paid to the employees.

Step
5
• Deposit of all statutory liabilities:
All statutory deductions are paid to the respective statutory bodies & funds.

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Employee Cost and Direct Expenses

Idle Time

The time during which no production is carried-out because

the worker remains idle but are paid.

Normal idle
time
Abnormal
idle time

Normal Idle Time: Time which cannot be avoided or

reduced in the normal course of business.

Time lost
between factory Interval between
gate and the one job and
place of work, another,

Causes:
Setting up Normal rest
time for the time, break for
machine, lunch etc.

• Treated as a part of cost of production.

• In the case of direct workers an allowance for normal idle time is

Treatment of Normal
considered while setting of standard hours or standard rate.
Idle Time
• In case of indirect workers, normal idle time is considered for the
computation of overhead rate.

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Employee Cost and Direct Expenses

Abnormal Idle Time: Apart from normal idle time, there may be factors
which give rise to abnormal idle time.

Power failure,
Lack of Breakdown of
coordination, machines,

Causes:
Strikes, Non-
lockouts, poor availability of
supervision, raw materials,
fire, flood etc.

Causes further analysed into

Controllable Uncontrollable
abnormal idle time abnormal idle time

Time which could have Time lost which

been put to productive management does not
use had the management have any control e.g.,
been more alert and breakdown of machines,
efficient. floods etc.

• Not included in production cost.

Treatment • Shown as a separate item in the Costing Profit and Loss Account.
of Abnormal • For each category i.e. controllable and uncontrollable idle time, the
Idle time break-up of cost due to various factors should be separately shown.

• Management should aim at eliminating controllable idle time.

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Employee Cost and Direct Expenses

Overtime

Overtime: Work done beyond normal working hours.

Wages paid for overtime Premium (extra) payment for

Overtime Payment
at normal rate overtime work

Overtime premium: Extra amount so paid over the normal rate

CAUSES TREATMENT

Urgency of work. Charged to job directly.

To make up shortfall in Treated as overhead cost of

production due to some the particular cost centre
unexpected development. which works overtime.

To make up shortfall in If overtime is worked in a department due

production due to some to the fault of another department, then
fault of management. premium should be charged to the latter
department.

To take advantage of an Overtime worked on account

expanding market or of rising demand. of abnormal conditions such as flood, etc.,
should be charged to Costing
P/L Account.

Systems of Wage Payment and Incentives

System of Wages Payment

Combination Premium Group Incentives

Output
Time based of time and Bonus bonus for indirect
based
output based method scheme workers

24 ©ICAI B O S
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Employee Cost and Direct Expenses

Time based (Time Rate System):

Workers are paid on time basis i.e. hour, day, week, or month.

Wages = Time Worked (Hours/ Days/ Months) × Rate for the time

Output Based (Piece Rate System):

Each operation, job or unit of production is termed a piece.

A rate of payment, is fixed for each piece.
The wages of the worker depend upon his output and rate of each unit of output.

Wages = Number of units produced × Rate per unit

Premium Bonus Method:

The worker is guaranteed his daily wages, if output is below and up to standard.
In case the task is completed in less than the standard time, the saved time is shared between the employees
and the employer.

• A standard time is fixed for each job or process

Halsey • Worker gets his time rate even if he exceeds the standard time limit,
Premium Plan since his day rate is guaranteed.

• If job done in less than the standard time, bonus equal to 50 percent of
the wages of time saved is paid.

Wages = Time taken × Time rate + 50% of time saved × Time rate

Advantages Of Disadvantages Of
Halsey Premium Plan Halsey Premium Plan

• Time rate is guaranteed. • Incentive is not so strong as with piece rate

system.
• Opportunity for increasing earnings by
increasing production. • Harder the worker works, the lesser he gets
per piece.
• System is equitable in as much as the
employer gets a direct return for his efforts in • Sharing principle may not be liked by
improving production methods. employees.

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Employee Cost and Direct Expenses

• Standard time allowance is fixed for performance of a job.

Rowan • Bonus is paid if time is saved.

Premium Plan
• Bonus is that proportion of the time wages as time saved bears to the
standard time.

Time Saved
Time taken × Rate per hour + × Time taken × Rate per hour
Time Allowed

Advantages Of Disadvantages Of
Rowan Premium Plan Rowan Premium Plan

• A worker can never double his earnings • System is a bit complicated.

even if there is bad rate setting.
• Incentive is weak at a high production level
• Suitable for encouraging moderately where the time saved is more than 50% of
efficient workers. the time allowed.

• Sharing principle appeals to the employer as • Sharing principle is not generally welcomed
being equitable. by employees.

Absorption of Wages

Elements Of Wages

Monetary payment Non-monetary benefits

• Basic wages, • Medical facilities;

• Dearness allowance, • Educational and training facilities;

• Overtime wages, • Recreational and sports facilities;

• Production bonus, • Housing and social welfare; and

• Employer’s contribution to PF, ESI and other • Cost of subsidised canteen and co-operative
funds, societies, etc.

• Leave pay, etc.

26 ©ICAI B O S
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Employee Cost and Direct Expenses

Efficiency Rating Procedures

If the time taken by a worker on a job the standard time, then he is rated efficient.

Time allowed as per standard

Efficiency in % = × 100
Time Taken

Need for Efficiency rating:

Payment
Helps
Firm has a direct management
following
system of relationship for preparing
manpower
payment by with the requirements
results
output

Factors for increasing Employee productivity:

Employing who possess right type of skill.

Placing the right type of person in the right job.

Training young and old workers by providing right types of opportunities.

Taking appropriate measures to avoid the situation of excess or shortage of employees.

Carrying out work study for fixation of wages.

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Employee Cost and Direct Expenses

Employee (Labour) Turnover

Employee Rate of change in the composition of employee force during a specified

Turnover period measured against a suitable index.

Methods to calculate Employee Turnover

Replacement Method Separation Method Flux Method

This considers actual This considers total number This considers both the
replacement of employees of employees separated number of replacements
irrespective of number of as well as the number of
persons leaving the separations
organisation

Number of employees Replaced during the period

Replacement method = × 100
Average number of employees during the period on roll

Number of employees Seperated during the period

Separation method = × 100
Average number of employees during the period on roll

Number of employees Seperated + Number of employees

Replaced during the period
Flux method = × 100
Average number of employees during the period on roll

Or
No. of Separations + No. of Accessions
(i.e. No. of Replacements + No. of New Joinings)
× 100
Average no. of employees during the period on roll

Newly recruited employees are also responsible for changes in the composition or work force, some
management accountants fail to take new recruitment for calculating employee turnover. The total
number of workers joining, including replacements, is called accessions.

28 ©ICAI B O S
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Employee Cost and Direct Expenses

Causes of Employee Turnover:

Change of jobs for betterment

Premature retirement

Personal Causes
Domestic problems/ Family responsibilities

Discontent over the jobs and working environment

Seasonal nature of the business

Shortage of raw material, power, slack market for the

Causes of product etc.
Employee Unavoidable
Causes
Turnover Change in plant location

Disability

Disciplinary measures

Dissatisfaction with job, remuneration, hours of work,

working conditions, etc.

Strained relationship with management

Avoidable
Causes
Lack of training facilities and promotional avenues

Lack of recreational and medical facilities

Low wages and allowances

Effects of Employee Turnover:

Even flow of production is disturbed

Efficiency of new workers is low

Increased cost of training

New workers cause increased breakage of tools

Cost of recruitment

©I CAI BOS 29
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Employee Cost and Direct Expenses

Cost of Employee Turnover:

Cost of Employees Turnover

Preventive Costs Replacement Costs

Costs incurred to prevent employee turnover or keep Costs which arise due to employee turnover
it as lowest as possible

Cost of medical Cost on employees’ Cost on other benefit

benefit welfare like pension with an objective to
etc. retain employees

Cost of Training and induction Abnormal breakage Extra wages and

recruitment and scrap overheads due to the
inefficiency of new
workers

30 ©ICAI B O S
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Overheads: Absorption Costing Method

Chapter Overview
Overheads

Administrative Overheads Selling and Distribution

Production Overheads
Overheads

Accounting and Control of

Overheads

Distribution of Overhead Rates Concepts related with

Overheads Capacity

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Overheads: Absorption Costing Method

Classification of Overheads
Overheads are the expenditure which cannot be identified with a particular cost unit. Overheads can be classified as
under.

Factory or Manufacturing or
Production Overheads

Office and Administrative Fixed Overheads

Overheads
By Function By Nature Variable Overheads
Selling and Distribution
Overheads Semi-Variable Overheads

Indirect materials By Element By Control Controllable costs

Indirect employee cost
Uncontrollable costs
Indirect expenses

Functional Classification of Overheads

One of the most important ways of classifying overheads is as per their function. As per this classification overheads
are classified as under.

Indirect cost incurred for manufacturing or production activity in

a factory. Manufacturing overhead includes all expenditures Factory or Manufacturing
incurred from the procurement of materials to the or Production Overheads
completion of finished product.

Expenditures incurred on all activities relating to general

management and administration of an organisation. It includes
formulating the policy, directing the organisation and Office and Administrative
controlling the operations of an undertaking which is not Overheads
related directly to production, selling, distribution, research or
development activity or function.

i) Selling overheads: expenses related to sale of products and include

all indirect expenses in sales management for the organisation. Selling and Distribution
(ii) Distribution overhead: cost incurred on making product available for Overheads
sale in the market.

32 ©ICAI B O S
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Overheads: Absorption Costing Method

Steps for Distribution of Overheads

Estimation of Overheads

Allocation of Overheads: Apportionment of

Direct assignment of cost Overheads: Allotment
to a cost object which can of proportions of items
be traced directly of cost to cost centres or
departments on some basis.

Production Production Service Service

Department-I Department-II Department-I Department-II

Re-apportionment of Overheads: The process of assigning service department overheads

to production departments is called reassignment or re apportionment. Methods of
reapportionment are:

(i) Direct re-distribution method

(ii) Step method of secondary distribution or non-reciprocal method

(iii) Reciprocal Service method.

Total Overheads: The sum of allocated, apportioned and reapportioned overheads is called
total overheads for a cost object.

Absorption of Overheads: Total overheads calculated as above is distributed over the

actual quantity of goods produced. The distribution of total estimated overheads to units of
production is called absorption of overheads.

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Overheads: Absorption Costing Method

Methods for Re-apportionment of Overheads

The re-apportionment of service department expenses over the production departments may be carried out by using
any one of the following methods:

Methods for Re-apportionment

Direct re-distribution Step method or non-reciprocal Reciprocal Service

method method. method.

Simultaneous Equation Trial and error method Repeated distribution

method method

Methods of Absorbing Overheads to various Products or Jobs

Several methods are commonly employed either individually or jointly for computing the appropriate overheads
rate. The more common of these are:

Percentage
Percentage Percentage Rate per unit
of Labour hour Machine hour
of of direct of
direct rate rate
prime cost labour cost Output
materials

Machine hour rate

Machine hour rate implies, cost of running a machine for an hour to produce goods.

The steps involved in determining of Machine hour rate is as follows:

Step
Calculate total of overheads apportioned to a production department.
1:

Step Apportion further these overheads to machines or group of machines in the

2: department.

Step
Allocate machine specific costs (directly identifiable with the machine)
3:

34 ©ICAI B O S
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Overheads: Absorption Costing Method

Step
Estimate total productive hours for the machine
4:

Step Aggregate overheads as apportioned in step-2 and allocated in step-3 and divide
5: it by Estimated total productive hours

The resultant figure is machine hour rate

Types of Overheads Rates

This rate
Normal Rate: is determined Blanket
in advance by It refers to the
This rate is estimating the Overheads Rate: computation
calculated by amount of the of one single
dividing the actual overheads for the Blanket overhead overhead rate for a
overheads by actual period in rate refers to the particular
base. It is also known which it is to be computation of one production unit or
as actual rate. used. single overhead rate department.
for the whole factory.

Pre-determined Departmental
Overhead Rate: Overhead Rate:

Treatment of Under-absorption and Overabsorption of overheads in Cost

Accounting
Is there any under/over
absorption of overheads?

Yes Yes
Amount of under/ over
absorption is small

No Costing P&L A/c

Due to wrong estimation
and abnormal reasons Yes

No

Calculate Supplementary Rate and Charge to Cost of Sales

A/c, Finished Goods A/c and W-I-P A/c

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Overheads: Absorption Costing Method

Concepts related with Capacity

Installed/ The maximum capacity of producing goods

or providing services. It is also known as
Rated theoretical capacity.
capacity

It is defined as actually utilised capacity of a Practical

plant. It is also known as operating capacity. capacity

The volume of production or services achieved or

Normal achievable on an average over a period under normal
capacity circumstances taking into account the reduction in
capacity resulting from planned maintenance.

Actual
Capacity actually achieved during a given period.
capacity

It is that part of the capacity of a plant, machine or

Idle
equipment which cannot be effectively utilised in
capacity production.

Treatment of Certain Items in Cost Accounting

Interest
and It includes any payment in nature of interest for use of non- equity funds and incidental cost that an
entity incurs in arranging those funds. Interest and financing charges shall be presented in the cost
financing
statement as a separate item of cost of sales.
charges

Cost of primary packing necessary for protecting the product or for convenient handling, should
Packing become a part of cost of production. The cost of packing to facilitate the transportation of the product
expenses from the factory to the customer should become a part of the distribution cost.

These indirect benefits stand to improve the morale, loyalty and stability of employees towards
Fringe the organisation. If the amount of fringe benefit is considerably large, it may be recovered as
benefits direct charge by means of a supplementary wage or labour rate; otherwise these may be
collected as part of production overheads.

If research is conducted in the methods of production, the research expenses should

be charged to the production overhead; while the expenditure becomes a part of the
Research administration overhead if research relates to administration. Similarly, market research
and
expenses are charged to the selling and distribution overhead.
Development
expenses Development costs incurred in connection with a particular product should be charged directly
to that product. Such expenses are usually treated as “deferred revenue expenses,” and
recovered as a cost per unit of the product when production is fully established.

36 ©ICAI B O S
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Activity Based Costing

Points Of Discussion

Concept Usefulness of ABC

Cost Hierarchy Steps

Meaning Of Activity Based Costing

• Accounting methodology that assigns costs to activities rather than

products or services.

Activity • Costs are assigned based on their use of resources.

Based Costing
• Creates a LINK BETWEEN THE ACTIVITY (resource consumption) and the
(ABC) COST OBJECT.

• Useful to the ORGANIZATION WITH MULTIPLE PRODUCTS.

Factors Prompting Development Of ABC

Growing overhead costs

Increased market competition

Increased product diversity

Decreased costs of information processing

©I CAI BOS 37
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Activity Based Costing

Usefulness/Suitability Of ABC

ABC is particularly needed in the following situations:

High amount Wide range Presence of

Stiff
of overhead of products non-volume
competition
related activities

Advantages And Disadvantages Of ABC

Advantages Disadvantages

• More accurate costing. • Expensive

• Overhead allocation is done on logical basis. • Not helpful to the small organizations.

• Enables better pricing policies. • May not be applied to organizations with

limited products.
• Utilizes unit cost rather than just total cost.
• Selection of the most suitable cost driver may
• Helps to identify non-value added activities. be difficult or complicated.

• Helpful to the organizations with multiple

products.

• Highlights problem areas which require

attention of the management.

Terms Used

(i) Activity • Event that incurs cost.

(ii) Cost Object • An item for which cost measurement is required

• Factor that causes a change in the cost of an activity-

(iii) Cost Driver • Resource cost driver: Measure of the quantity of resources.

• Activity cost driver: Measure of the frequency and intensity of demand.

38 ©ICAI B O S
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Activity Based Costing
Examples of Cost Driver business function wise:

Research and Design of products,

Customer Marketing Distribution
Development services and
Service
procedures

Number of Number of Number of Number of Number

research products in service calls advertisements of units
projects design distributed

Personnel Number of Number of Number

Number of
hours on a parts per products of sales
customers
project product serviced personnel

Number of Hours spent Sales

engineering on servicing revenue
hours products

• Group of various individual cost items.

(iv) Cost Pool
• after Example machine set-up.

Cost Allocation

Linked through Linked through

Overhead Cost
Costs Activities Objects
Resource Cost Activity Cost
Drivers Drivers

©I CAI BOS 39
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Activity Based Costing

Requirements In ABC Implementation

Requirements

Staff Training Process Activity

Specification Definition

Activity Driver
Assigning Cost
Selection

Traditional Absorption Costing Vs ABC

Traditional Based on Machine

Costing hours, labour Hours, Volume etc.

Cost
Allocation

Activity based
Based on Cost Driver
Costing

40 ©ICAI B O S
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Activity Based Costing

Activity Based Costing Traditional Absorption Costing

Related to activities Related to cost centers

More realistic Not realistic

Activity–wise cost drivers Time (hours) - only cost driver

Cost are assigned to cost objects Costs are assigned to cost units

Aids cost control Not suitable for cost control.

LEVEL OF ACTIVITIES UNDER ABC METHODOLOGY/COST HIERARCHY

Unit level activities

Activities which can be • Indirect materials/ consumables
identified with the number of
units produced. • Inspection or testing of every item produced

Batch level activities

Activities which are performed each • Material ordering
time a batch of goods is produced. • Machine set-up costs

Product level activities

Activities which are performed to • Designing the product
support different products in product • Producing parts specifications
line.

Facilities level activities

Activities which are common • Maintenance of buildings
and joint to all products • Plant security
manufactured.

©I CAI BOS 41
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Activity Based Costing

Stages In Activity Based Costing (ABC)

Identify different activities Break the organisation down into many

within the organisation small activities.

Relate the overheads to This creates ‘cost pools’ or ‘cost buckets’.

the activities

Support activities are

then spread across the Where base is the cost driver measuring,
primary activities how the support activities are used.

Determine the To relate the overheads collected in cost pools to

activity cost drivers the cost objects.

Calculate activity
cost driver rates Calculate activity cost driver rates for each activity

Total cost of activity

Activity cost driver rate =
Activity driver

42 ©ICAI B O S
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Activity Based Costing

Examples of Cost Drivers

Activity Cost Pool Cost Drivers

Ordering and Receiving

Materials cost Number of purchase orders

Setting up machines
Number of set-ups
costs

Machine costs Machine hours

Assembling costs Number of parts

Inspecting and testing

Number of tests
costs
Overhead
Costs
Painting costs Number of parts

Supervising Costs Direct labour hours

Delivery cost Number of deliveries

Shelf-stocking cost Shelf-stocking hours

Customer Support Number of items sold

How to calculate cost per product using ABC?

If it is given that,

Activity Cost (`) Particulars Product 1 Product 2

Ordering 64,000 No. of Purchase Orders 30 50
Delivery 1,40,000 No. of Deliveries 110 90
Shelf stocking 80,000 Shelf Stocking Hours 220 180

©I CAI BOS 43
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Activity Based Costing
Then, cost per product as per ABC

Activity Total Cost (`) Cost Driver Cost Driver Cost Driver Product 1 (`) Product 2 (`)
Level Rate (`)
(a) (b) (c) (d) (e) = (b)/(d) (f) (g)
Ordering 64,000 No. of 80 800 24,000 40,000
Purchase (30+50) (800 x 30) (800 x 50)
Orders
Delivery 1,40,000 No. of 200 700 77,000 63,000
Deliveries (110 + 90) (700 x 110) (700 x 90)
Shelf stocking 80,000 Shelf Stocking 400 200 44,000 36,000
Hours (220 +180) (200 x 220) (200 x 180)

Practical Applications Of Activity Based Costing

As a Decision-Making Tool

Improve
performance and
profitability

Decision w.r.t.
introduction of new
product or vendor

Decisions related to
facility and resource
expansion

Decision support
for human resources

Helps in determining
price based on cost
plus markup basis

44 ©ICAI B O S
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Activity Based Costing

As Activity Based Management

Activity Based Cost Management

(ABM): Using ABC to manage costs at
activity level.

Cost Driver Activity Performance

Analysis Analysis Analysis

Non-Value-
Value-Added
Added Activities
Activities (VA)
(NVA)

Business Process Performance

Cost Reduction Benchmarking
Re-engineering Measurement

Facilitate Activity Based Budgeting (ABB)

It analyses the resource input or cost for each activity. It is the reversing of the ABC process to produce nancial
plans and budgets.

Key Elements Benefits

• Type of work to be done • Enhance accuracy of financial forecasts

• Quantity of work to be done • Increasing management understanding

• Cost of work to be done • Rapidly and accurately produce financial plans

• Eliminates much of the needless rework

©I CAI BOS 45
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Cost Sheet
Points of Discussion

Head of
Functional Costs in Cost
Classification Sheet

Format of Advantages
Cost Sheet of Cost Sheet

Functional Classification of Elements of Cost

Direct Material Cost

Direct Employee (labour) Cost

Direct Expenses

Production/ Manufacturing Overheads

Administration Overheads

Selling Overheads

Distribution Overheads

Research and Development costs etc.

46 ©ICAI B O S
 SA R AN S H
Cost Sheet

Cost Heads in a Cost Sheet

Prime Cost

Cost of Production

Cost of Goods Sold

Cost of Sales

©I CAI BOS 47
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Cost Sheet

Prime Cost:

Direct Direct Direct Prime

material employee expenses Cost
costs costs

Cost of material

Freight inwards
Direct Cost of direct
Material material Insurance
Cost consumed' e.g.
Trade discounts or rebates (to be deducted)

Duties & Taxes (if ITC is not available / availed).

Wages and salary

Allowances and incentives

Payments to
the employees
Direct engaged in the Payment for overtime
Employee production
Cost of goods and Bonus / ex-gratia
provision of
services e.g. Employer’s contribution to PF, ESI & funds

Other benefits (medical, leave with pay, LTC).

Power & fuel

Royalty paid
Expenses other
than direct
material cost Hire charges
Direct
and direct
Expenses
employee cost Fee for technical assistance
e.g.
Amortised cost of moulds, patterns, patents

Other expenses directly related with the production

of goods.

Opening Closing Direct

Addition/
Stock of stock of materials
Purchases
Material Material consumed

48 ©ICAI B O S
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Cost Sheet

Cost of Production:

Factory related Cost of

Prime cost costs and overheads Production

Prime Cost xxxx

Add: Factory Overheads #
xxx
Gross Works Costs xxxx
Add: Opening stock of Work-in-process xxx
Less: Closing stock of Work-in-process (xxx)
Factory or Works Costs xxxx
Add: Quality Control Cost xxx
Add: Research & Development cost (Process related) xxx
Add: Administrative Overheads related with production xxx
Less: Credit for recoveries (miscellaneous income) (xxx)
Add: Packing Cost (Primary packing) xxx
Cost of Production xxxx

# Factory Overheads (Works / production / manufacturing overheads) includes-

Consumable Lease rent of

stores and spares Depreciation production assets

Repair and maintenance Indirect employees cost Drawing and

of plant and machinery, related with production Designing
factory building activities department cost

Service
Insurance of plant department cost
and machinery, Amortised cost
of jigs, fixtures, such as Tool Room,
factory building, Engineering &
stock of raw tooling
Maintenance,
material & WIP Pollution Control

©I CAI BOS 49
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Cost Sheet

Cost of Goods Sold:

Cost of Cost of
Opening Closing Cost of
Cost of
stock of stock of Goods Sold
Production
finished finished
goods goods

Cost of Sales:

Cost of Goods Sold xxxx

Add: Administrative Overheads (General) xxx
Add: Selling Overheads xxx
Add: Packing Cost (secondary) xxx
Add: Distribution Overheads xxx
Cost of Sales xxxx

Examples:

Administrative Selling Packing Cost Distribution

Overheads (General) Overheads (secondary) Overheads

Depreciation and Salary and wages Salary and wages of

Packing material
maintenance of, office related with sales employees engaged in
that enables to
building, furniture etc. department distribution of goods
store, transport, and
make the product
marketable.
Salary of administrative Rent, depreciation, Transportation and
employees, maintenance related insurance costs related
accountants, etc. with sales department with distribution

Rent, rates & taxes

Advertisement, Depreciation, hire charges,
maintenance of website maintenance and other
for online sales, market operating costs related
research etc. with distribution.
Insurance, lighting, office
expenses

Indirect materials-printing
and stationery,
office supplies etc.

Legal charges, audit fees,

meeting expenses etc.

50 ©ICAI B O S
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Cost Sheet

Cost Sheet- Specimen Format

Particulars Total Cost (`) Cost per unit (`)

1. Direct materials consumed:
Opening Stock of Raw Material xxx
Add: Additions/ Purchases xxx
Less: Closing stock of Raw Material (xxx)
xxx xxx
2. Direct employee (labour) cost xxx
3. Direct expenses xxx
4. Prime Cost (1+2+3) xxx xxx
5. Add: Works/ Factory Overheads xxx
6. Gross Works Cost (4+5) xxx
7. Add: Opening Work in Process xxx
8. Less: Closing Work in Process (xxx)
9. Works/ Factory Cost (6+7-8) xxx xxx
10. Add: Quality Control Cost xxx
11. Add: Research and Development Cost xxx
12. Add: Administrative Overheads (relating to production activity) xxx
13. Less: Credit for Recoveries/Scrap/By-Products/ misc. income (xxx)
14. Add: Packing cost (primary) xxx
15. Cost of Production (9+10+11+12-13+14) xxx xxx
16. Add: Opening stock of finished goods xxx
17. Less: Closing stock of finished goods (xxx)
18. Cost of Goods Sold (15+16-17) xxx xxx
19. Add: Administrative Overheads (General) xxx
20. Add: Marketing Overheads :
Selling Overheads xxx
Distribution Overheads xxx
21. Cost of Sales (18+19+20) xxx xxx

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Cost Sheet

Treatment of various items of cost in Cost Sheet:

• Any abnormal cost, where it is material and quantifiable, shall not

Abnormal costs form part of cost of production or acquisition or supply of goods or
provision of service.

Subsidy/ Grant/
• Reduced from the cost objects to which such amount pertains.
Incentives

Penalty, fine,
damages, and • Does not form part of cost.
demurrage

Interest and • Not included in cost of production.

other finance
• Shall be presented in the cost statement as a separate item of cost of
costs sales.

Advantages of Cost Sheet

Provides the total

cost figure as
well as cost per
unit of
production.

Advantages
Helps in cost of Cost
comparison.
Sheet

Facilitates
Facilitates
cost control by
preparation of
disclosing
cost estimates
operational
required for
efficiency.
submitting
tenders. Provides sufficient
help in arriving
at the
figure of selling
price.

52 ©ICAI B O S
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Cost Accounting Systems

Points of Discussion

Non-Integral accounting system Integral accounting system

Reconciliation of Cost and Financial Accounts

Non-integrated Accounting System

SEPARATE LEDGERS are maintained for both cost and financial accounts.

This system is also known as COST LEDGER ACCOUNTING SYSTEM.

This system contains limited ACCOUNTS due to the exclusion of purchases, expenses and also Balance Sheet
items like fixed assets, debtors and creditors.

ITEMS OF ACCOUNTS excluded are REPRESENTED BY COST LEDGER CONTROL ACCOUNT.

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Cost Accounting Systems

Integrated Accounting System

COST AND FINANCIAL ACCOUNTS are kept in the SAME SET of books.

PROVIDES RELEVANT INFORMATION necessary for preparing profit and loss account and the balance sheet.

Non-Integrated Accounting System

Manufacturing/
Cost Ledger Stores Ledger Wages
Production/Works/
Control Control Control
Factory Overhead
Account Account Account
Control Account

Administrative Finished Selling and

Work-in-Progress Overhead Goods Distribution
Control Account Control Control Overhead
Account Accounts Control Account

Cost of Costing Overhead

Sales Profit & Loss Adjustment
Account Account Account

Flowchart

Materials Control A/c

Wages Production
Control A/c Overhead Control A/c
Work in Progress
Control A/c

Administration Finished Goods

Overhead Control A/c Control A/c

Cost of Goods
Sold Control A/c

Cost of Sales Selling & Distribution

Control A/c Overhead Control A/c

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Cost Accounting Systems

Integrated Accounting System

Advantages

• No need for reconciliation

• Less efforts

• Less time consuming

• Economical process

In integrated system, all accounts necessary for showing classification of cost will be used but the cost ledger
control account of nonintegrated accounting is replaced by use of following accounts:

Bank account Receivables Payables

(Debtors) account (Creditors) account

Provision for Fixed assets Share capital

depreciation account account account

Reconciliation Of Cost And Financial Accounts

Reconciliation is done when cost and financial accounts are kept separately

Reconciliation of the balances of two sets of accounts is possible by preparing a MEMORANDUM RECONCILIATION
ACCOUNT

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Cost Accounting Systems

Causes of differences in Financial and Cost Accounts

Interest on loans

Expenses and discounts on issue of shares

Loss by are not covered by insurance

Purely Financial
Expenses Losses on the sales of fixed assets

Income tax, donations

Items included in
Financial Accounts only
Interest received on bank deposits

Purely Financial Income Dividends received

Profits on the sale of fixed assets

Rent receivables

Charges in lieu of rent where premises are owned

Items included in Interest on capital at notional figure

Cost though not incurred
Accounts only
(notional
Salary for the proprietor at notional figure
expenses)

Notional Depreciation on the assets fully

depreciated

Items whose
LIFO may be adopted for cost accounts
treatment is
different in the two
sets of accounts Different method of depreciation may be
followed

Varying basis of Valuation of stock (at cost in cost accounting)

valuation

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Cost Accounting Systems

Procedure for Reconciliation

3. Reconciliation of
both the profits

2. Ascertainment
of profit as per
cost accounts
1. Ascertainment
of profit as per
financial accounts

Example:

Profit as per Cost Accounts after following adjustment `3,00,000

Factory overheads absorbed `5,00,000

Selling & Distribution Overhead absorbed `2,00,000

Valuation of closing stock of finished goods `1,23,000

Administrative Overhead absorbed `1,93,000

Profit as per financial accounts after following adjustment `1,10,000

Factory overheads charged `4,50,000

Selling & Distribution Overhead charged `1,80,000

Valuation of closing stock of finished goods `1,50,000

Administrative Overhead charged `2,60,000

Interest on loan `2,20,000

Now, reconciliation between Financial and Cost Accounts can be done by preparing RECONCILIATION
STATEMENT as follows:
(Rs.) (Rs.)
Profit as per Cost Accounts 3,00,000
Add: Factory overheads over-absorbed (`5,00,000 – `4,50,000) 50,000

Selling & Dist. Overhead over-absorbed (`2,00,000 – `1,80,000) 20,000

Difference in the valuation of closing stock of finished goods (`1,50,000 – `1,23,000) 27,000 97,000

3,97,000
Less: Admn. overhead under-absorbed (`2,60,000 – `1,93,000) 67,000

Interest on loan 2,20,000 2,87,000

Profit as per financial accounts 1,10,000

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Unit & Batch Costing

Points of Discussion

Meaning
Unit
Costing Process of Cost Accumulation
and Calculation
Methods of
Costing
Meaning

Batch Process of Cost Accumulation and Calculation

Costing
Determination of Economic Batch Quantity (EBQ)

Difference between Job and Batch Costing

Unit Costing

Meaning of Unit Costing

• where the output produced is identical and each unit of output requires
identical cost.
Unit
• also known as single or output costing.
Costing
• applied in industries like PAPER, CEMENT, STEEL WORKS, MINING, BREWERIES
ETC.

Here, costs are collected and analysed element wise and then total cost per unit is ascertained as follows:

Total cost of production

Cost per unit =
No. of units produced

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Unit & Batch Costing

Cost Collection Procedure In Unit Costing

Collection of
Collection of Employees Collection of
Materials Cost (labour) Cost Overheads

It is collected Direct employee

These are collected under
from Material cost: It is collected
suitable standing orders
Requisition notes. from job time
numbers, and selling and
cards or sheets.
distribution overheads against
cost accounts numbers.
Accumulated
material cost is The time booked/
then posted in cost recorded is valued
accounting system. at appropriate rates Total expenses so collected are
and entered in the apportioned to service and
cost accounting production departments
system. on some suitable basis.

Indirect employee The expenses of service

costs: these are departments are finally
collected from transferred to production
the payrolls books departments.
and posted against
standing order
or expenses code
numbers in the The total overhead of production
overhead expenses departments is then applied to
ledger. products on some realistic basis,
e.g. machine hour;
labour hour etc.

Treatment Of Spoiled And Defective

Loss due to Loss due to

normal reasons abnormal reasons

Actual number Cost of rectification and

of defectives Number of defective units
loss is treated as abnormal
is within the substantially exceeds the
cost and is written off as
normal limit normal limits
loss in Costing Profit and
Loss Account.

Cost of Cost of rectification

rectification or loss beyond normal
or loss will be limits are written off
charged to the in Costing Prot and
entire output Loss Account

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Unit & Batch Costing

Batch Costing

Meaning of Batch Costing

• is a type of specific order costing where articles are manufactured in

predetermined lots, known as batch.
Batch
Costing • the cost object for cost determination is a batch for production.

• example PEN MANUFACTURING INDUSTRY

A batch consists of certain number of units which are PROCESSED SIMULTANEOUSLY. Under this method of
manufacturing, the inputs are accumulated in the assembly line till it reaches minimum batch size. Soon after a
batch size is reached, all inputs in a batch is processed for further operations.

Costing Procedure In Batch Costing

Material cost Labour cost Overheads

Multiplying the time spent on Absorbed on some suitable
On the basis of material
the batch by direct workers as basis like machine hours, direct
requisitions for the batch.
ascertained from time cards or labour hours etc.
job tickets.

Economic Batch Quantity (EBQ)

Primarily, the total production cost under batch production comprises of two main costs, namely,

Machine Inventory
Set up holding
Costs costs

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Unit & Batch Costing

Balancing Machine set up cost and Inventory holding cost

• Set up cost may decline due to lesser number of set ups. Lower lot size
• But units in inventory will go up leading to higher holding costs
• Lower inventory holding costs.

Higher lot size • But higher set up costs due to high number of set ups.

Economic Batch • It is the size of a batch where total cost of set-up and holding costs are
Quantity (EBQ) at minimum.

Cost/unit
Total cost
Inventory
carrying
cost

Set-up cost

Batch Size

Determination of EBQ

By calculating the total cost for a series of possible batch sizes and checking which batch size gives the minimum
cost.

Mathematical formula:

Where, D = Annual demand for the product

S = Setting up cost per batch
C = Carrying cost per unit of production

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Unit & Batch Costing

Difference Between Job And Batch Costing

Sr. No Job Costing Batch Costing

1 Used for non- standard and non- repetitive Homogeneous products produced in a continuous
products produced as per customer production flow in lots.
specifications and against specific orders.
2 Cost determined for each Job. Cost determined in aggregate for the entire Batch and
then arrived at on per unit basis.
3 Jobs are different from each other and Products produced in a batch are homogeneous and lack
independent of each other. Each Job is unique. of individuality.

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Job Costing

Meaning Of Job Costing

• It is applicable where the work consists of separate contracts, jobs or

Job batches, each of which is authorised by specific order or contract.
Costing • Industry example: PRINTING; FURNITURE; HARDWARE; SHIP BUILDING;
HEAVY MACHINERY; INTERIOR DECORATION.

Principles Of Job Costing

Analysis and ascertainment of cost of each unit of production

Control and regulate cost

Determine the profitability

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Job Costing

Process Of Job Costing

Prepare a separate cost sheet for each job

Disclose cost of materials issued for the job

Employee costs incurred (on the basis of bill of material and time cards respectively)

When job is completed, overhead charges are added for ascertaining total expenditure

Suitability Of Job Costing

When jobs are When no two Where the work-

executed for orders are alike in-progress differs
different customers and each order/ from period to
according to their job needs special period on the basis
specifications. treatment. of the number of
jobs in hand.

Job Cost Card/ Sheet

A cost sheet where,

Job Cost • quantity of materials issued,
Card/Sheet
• hours spent by different class of employees,

• amount of other expenses and share of overheads are recorded.

64 ©ICAI B O S
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Job Costing

Format of Job Cost Sheet

JOB COST SHEET

Description: Job No.:

Blue Print No.: Quantity:
Material No.: Date of delivery:
Reference No.: Date commenced:
Date finished:

Date Reference Details Material Labour Overhead

Total

Summary of costs Estimated (`) Actual (`)

For the job
Direct material cost Direct Units produced
wages Cost/unit
Production overhead Remarks
PRODUCTION COST Prepared by:
Administration and Checked by:
Selling & Distribution
Overheads

TOTAL COST
PROFIT/LOSS
SELLING PRICE

Collection Of Costs For A Job

Materials cost Labour cost Overheads

Traced to and Booked against Manufacturing overheads are

identified with specific specific jobs in the job collected under suitable
job or work order time cards or sheets standing order numbers

Selling and distribution

overheads are collected
Posted to individual Posted to the against cost accounts
job cost sheets or appropriate job cost numbers
cards in the work-inprogress card or sheet in working
ledger progress ledger
Total overhead expenses are
apportioned to service and
production departments on
some suitable basis.
If the surplus material
is utilised on some
The expenses of service
other job, instead of
departments are finally
being returned to the
transferred to production
stores first, a material
departments.
transfer note is
prepared.
The total production overhead
is then applied to products on
some realistic basis.

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Job Costing

Spoiled And Defective Work

Meaning

Spoiled work It is the quantity of production that has been totally rejected and cannot be rectified.

Defective It refers to production that is not as perfect as the saleable product but is capable of
work being rectified

Treatment

Where a percentage
of defective work
is ALLOWED in a The cost of rectification will be charged to the whole job and
particular batch spread over the entire output of the batch
AS IT CANNOT BE
AVOIDED.

Where defect is
DUE TO BAD The cost of rectification shall be written o as a loss being an
WORKMANSHIP. abnormal cost

Where defect is due

to the inspection
department Wrongly Cost of rectification will be charged to the department and
ACCEPTING INCOMING will not be considered as cost of manufacture of the batch
MATERIAL OF POOR
QUALITY.

66 ©ICAI B O S
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Job Costing

Accounting Of Costs For A Job

1. For purchase of materials

Stores Ledger Control A/c Dr.

To Cost Ledger Control A/c

2. For the value of direct materials issued to jobs

Work-in-Process Control A/c Dr.

To Stores Ledger Control A/c

3. For return of direct materials from jobs

Stores Ledger Control A/c Dr.

To Work-in-Process Control A/c

4. For return of materials to suppliers

Cost Ledger Control A/c Dr.

To Stores Ledger Control A/c

5. For indirect materials

Factory Overhead Control A/c Dr.

To Stores Ledger Control A/c

6. For wages paid

Wages Control A/c Dr.

To Cost Ledger Control A/c

7. For direct wages incurred on jobs

Work-in-Process Control A/c Dr.

To Wages Control A/c

8. For indirect wages

Factory Overhead Control A/c Dr.

To Wages Control A/c

9. For any indirect expense paid

Factory Overhead Control A/c Dr.

To Cost Ledger Control A/c

10. For charging overhead to jobs

Work-in-Process Control A/c Dr.

To Factory Overhead Control A/c

11. For the total cost of jobs completed

Cost of Sales A/c Dr.

To Work-in-Progress Control A/c

12. The balance of Cost of Sales A/c is transferred to Costing Profit and Loss A/c; For such
transfer

Costing Profit and Loss A/c Dr.

To Cost of Sales A/c

13. For the sales value of jobs completed

Cost Ledger Control A/c Dr.

To Costing Profit and Loss A/c

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Job Costing

Advantages And Disadvantages Of Job Costing

Details of Cost of material, labour and overhead for all job is

available to control.

Protability of each job can be derived.

Advantages
Facilitates production planning.

Budgetary control and Standard Costing

can be applied in job costing.

Spoiled and defective can be identied and responsibilities

can be fixed accordingly.

It is a costly and laborious method.

Chances of error is more as lot of clerical process is involved.

Disadvantages
This method not suitable in inflationary condition.

Previous records of costs will be meaningless if there is any change in

market condition.

Difference Between Job Costing And Process Costing

Job Costing Process Costing

Process of producing the product has a continuous

A Job is carried out by specific orders.
flow and the product produced is homogeneous.

Costs are compiled on time basis i.e., for each

Costs determined for each job.
process or department.

Each job is separate and independent. Products lose their individual identity.

Each job has a number and costs are collected The unit cost of process is an
against the same job number. average cost for the period.

Costs are computed when a Costs are calculated at the end

job is completed. of the cost period.

More managerial attention is

Control here is comparatively easier.
required for effective control.

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Process and Operation Costing

Chapter Overview
Process and Operation Costing

Costing Treatment of Inter-process Operation

Meaning Process loss/ Valuation of
Procedure WIP Profit Costing
gain

Process
Normal Abnormal Costing Equivalent
Methods Units

Meaning of Process Costing

Process Costing is a method of costing used in industries where the material has to pass through two or more processes
for being converted into a final product. It is defined as “a method of Cost Accounting whereby costs are charged to
processes or operations and averaged over units produced”.

This can be understood with the help of the following diagram:

Raw
Material Process-II Finished
Goods

Process-I Process-III

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Process and Operation Costing

Costing Procedure in Process Costing

Materials: Each process for which the materials are used, are debited with the cost of
materials consumed on the basis of the information received from the Cost Accounting
department.

Employee Cost (Labour): Each process account should be debited with the labour cost or wages paid
to labour for carrying out the processing activities. Sometimes the wages paid are apportioned over the
different processes after selecting appropriate basis.

Direct expenses: Each process account should be debited with direct expenses like depreciation, repairs,
maintenance, insurance etc. associated with it.

Production Overheads: These expenses cannot be allocated to a process. The suitable way out to recover
them is to apportion them over different processes by using suitable basis.

Steps in Process Costing

Step-1: Analyse the Physical Flow of Production Units

Step-2: Calculate Equivalent Units for each Cost Elements

Step-3: Determine Total Cost for each Cost Element

Step-4: Compute Cost Per Equivalent Unit for each Cost Element

Step-5: Assign Total Costs to Units Completed and Ending WIP

70 ©ICAI B O S
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Process and Operation Costing

Treatment of Normal, Abnormal Loss and Abnormal Gain

Normal Process Abnormal

Loss Abnormal Process
Process Loss
Gain/ Yield

• The cost of normal • The cost of an abnormal • The process account

process loss in practice process loss unit is equal to under which abnormal
is absorbed by good the cost of a good unit. The gain arises is debited with
units produced under total cost of abnormal process the abnormal gain and
the process. The amount loss is credited to the process credited to abnormal gain
realised by the sale of account from which it arises. account which will be
normal process loss units closed by transferring to
should be credited to the • Total cost of abnormal process the Costing Profit and Loss
process account. loss is debited to costing profit account.
and loss account.

Valuation of Work-in-process
The valuation of work-in-process presents a good deal of difficulty because it has units under different stages of
completion from those in which work has just begun to those which are only a step short of completion.

(i) Equivalent Units

Equivalent units or equivalent production units, means converting the incomplete production units into their equivalent
completed units. Under each process, an estimate is made of the percentage completion of work-in-process with
regard to different elements of costs, viz., material, labour and overheads.

The formula for computing equivalent completed units is:

Actual number of units in Percentage of
Equivalent completed units = X
the process of manufacture Work completed

Input Details Units Output Units Equivalent Units

Particulars
Material Labour Overhead

( ) ( )
% Units % Units % Units

x
Actual number
of units in thea Percentage of
Equivalent completed units = b c= a×b d e=a×d f g=a×f
process of Work completed
Opening xxx Opening manufacture
W-I-P* xxx xxx xxx xxx xxx xxx xxx
W-I-P
Unit xxx Finished xxx xxx xxx xxx xxx xxx xxx
Introduced output**
Normal loss*** xxx - - - - - -
Abnormal loss/ xxx xxx xxx xxx xxx xxx xxx
Gain****
Total Closing W-I-P xxx xxx xxx xxx xxx xxx xxx
xxx Total xxx xxx xxx xxx

* Equivalent units for Opening W-I-P is calculated only under FIFO method. Under the Average method, it is not shown separately.
**Under the FIFO method, Finished Output = Units completed and transferred to next process less Opening WIP. Under Average
method, Finished Output = Units completed and transferred.
***For normal loss, no equivalent unit is calculated.
****Abnormal Gain/ Yield is treated as 100% complete in respect of all cost elements irrespective of percentage of completion.

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Process and Operation Costing

(ii) Methods for valuation of work-in-process

First-in-first-out (FIFO) method Weighted Average (Average) Method

Under this method the units completed Under this method, the cost of opening
and transferred include completed work-in-process and cost of the
units of opening work-in-process current period are aggregated and the
and subsequently introduced units. aggregate cost is divided by output in
Proportionate cost to complete the terms of completed units.
opening work-in-process and that to
process the completely processed
units during the period are derived
separately.

Inter Process Profit

In some process industries the output of one process is transferred to the next process
not at cost but at market value or cost plus a percentage of profit. The difference between
cost and the transfer price is known as interprocess profits.

Operation Costing

This product costing system is used when an entity produces more than one variant
of final product using different materials but with similar conversion activities. Which
means conversion activities are similar for all the product variants but materials differ
significantly. Operation Costing method is also known as Hybrid product costing system
as materials costs are accumulated by job order or batch wise but conversion costs
i.e. labour and overheads costs are accumulated by department, and process costing
methods are used to assign these costs to products.

72 ©ICAI B O S
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Joint Products And By Products

Points Of Discussion

Joint Products &

By-Products

Meaning of Joint Treatment of

Products and By-Product Cost in
By-Products Cost Accounting

Apportionment of
Joint Costs

Meaning of Joint Products and By-Products

Joint
By-Products#
Products*

Two or more Products recovered from-

products
separated in • material discarded in
the course of main process.
same processing
• production of some
operation.
major products.

*OIL INDUSTRY PRODUCING JOINT PRODUCTS using crude petroleum like

gasoline, fuel oil, lubricants, paraffin, asphalt, kerosene etc.

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Joint Products And By Products

Petroleum
Gas

Gasoline
(Petrol)

Kerosene

Crude
Oil Diesel

Industrial
Fuel Oil

Lubricating
Oil, Paraffin
Wax and
Asphalt

Petroleum Refining Processes1

# MOLASSES IS PRODUCED AS A BYPRODUCT in the process of sugar manufacturing

Sugar Manufacturing Process2

Point at which products are separated from the main product is known as SPLIT-OFF POINT.

74 ©ICAI B O S
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Joint Products And By Products

Distinction Between Joint Products and By-Products

Joint Products By-Products

• Equal importance. • Small economic value.

• Produced simultaneously. • Incidental to the main product.

Co-Products

Co-Products

Joint products and co-products are used synonymously, but a distinction is there.

Co-products are two or more products which are contemporary but do not emerge necessarily from
the same material in the same process.

For instance,

wheat and gram produced in two separate farms

with separate processing of cultivation are co- Timber boards made from different trees
products. are co-products.

Methods Of Apportionment Of Joint Cost To Joint Products

Physical
Units Method

Net Realisable
Value at
Methods for split-off point
apportioning
joint cost Using Technical
Estimates Market value at the point of separation

Market value after further processing

Other
methods
Average unit cost method

Contribution margin method

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Joint Products And By Products

Physical Units Method:

Joint costs here are apportioned on the basis of some physical base, such as weight, numbers etc.

Net Realisable Value at Split-off Point Method:

Joint costs here are apportioned on the basis of Net Realisable Value at Split-off Point.

Net Realisable Value At Split-Off Point

sales value of joint products after processing

Estimated profit margins

Selling and distribution expenses

Post split- off costs

Using Technical Estimates:

This method is used WHEN -

Result obtained by above methods does not match with the resources consumed by
joint products, or;

Realisable value of the joint products are not readily available.

Other Methods:
(i) Market value at the point of separation

Useful method where further processing costs are incurred disproportionately.

To determine the apportionment of joint costs over joint products, a multiplying factor is determined as follows:

Joint Cost
Multiplying factor: x 100
Total Sales Revenue

Alternatively, joint cost may be apportioned in the ratio of sales values of different joint products.

76 ©ICAI B O S
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Joint Products And By Products

(ii) Market value after further processing

Basis of apportionment of joint cost is the total sales value of finished products.

Use of this METHOD IS UNFAIR WHERE -

Further processing costs after the point of separation are disproportionate, or;

All the joint products are not subjected to further processing.

(iii) Average Unit Cost Method

Total process cost (up to the point of separation)

Average unit cost =
Total units of joint product produced

Physical unit method also follows the same steps of calculation as followed under Average unit cost method, ultimately
giving the same outcome.

(iv) Contribution Margin Method

Variable

Joint costs segregated

into two parts

Fixed

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Joint Products And By Products

Variable costs

Apportioned on the basis of units produced In case products are further processed after point of
(average method or physical quantities) separation, then all variable cost incurred should be
added to the variable costs determined earlier.

Total variable cost is arrived at which is deducted from their

respective sales values to ascertain their contribution.

Fixed costs

Thereafter, fixed costs are apportioned over the joint products on the basis of the contribution ratios.

Methods of Apportionment of Joint Cost To By-Products

Methods for
apportioning
joint cost

Net Realisable Standard cost in Comparative Re-use basis

Value method Technical price
Estimates

78 ©ICAI B O S
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Joint Products And By Products

Net Realisable Value method:

No further processing required Further processing required

Additional expenses so incurred be deducted

Realisation on the disposal of the by-product
from the total value realised from the sale of the
deducted from the total cost of production.
by-product.

Only the net realisations should be deducted from the

total cost of production to arrive at the cost of
production of the main product.

Standard cost in Technical Estimates:

This method may be adopted where by-product is not saleable.

It may be valued at standard costs.

Standard cost may be determined by averaging costs recorded in the past and making technical estimates
of the number of units of original raw material going into the main product
and the number forming the by-product; or by adopting some other consistent basis.

Comparative price:

Value of by-product is ascertained with reference to the price of -

Similar material, or; Alternative material

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Joint Products And By Products

Re-use basis:

Sometimes, by-product may be of such a nature that it can be reprocessed in the

same process as part of the input of the process.

In that case, value put on by-product should be However, if the by-product can be put into an earlier
same as that of the materials introduced into process only, the value should be the same as for
the process. the materials introduced into the process.

Treatment Of By-Product Cost In Cost-Accounting

Sales value credited to Costing P & L Account

Small total
value
Deducted from total costs
Treatment of
by-product Considerable May be regarded as joint products rather than as
cost in cost- total value by-products
accounting

Require further Net realisable value of the by-product at

processing the split-off point may be arrived

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Service Costing

Points of Discussion

Application of
Service Costing

Service Costing vs
Product Costing

Methods of Composite Unit

Ascertaining
Service Service cost unit
Equivalent Unit
Costing
Service Cost
Statement

Costing of Services:
(i) Transport
(ii) Hotels & Lodges
(iii) Hospitals
(iv) Information
Technology Enabled
Services
(v) Toll Roads
(vi) Educational Institutes
(vii) Insurance
(viii) Financial Institutes
(ix) Others

When Is Service Costing Applied?

Internal application External application

When service provided by When services are offered

service cost centre to other to outside customers as a
responsibility centre profit centre

Example- Use of canteen services by Example- Hospitality services provided

hospital staff, operation of fleet of trucks for by a hotel, provision of services by
transport of raw material to factory financial institutions

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Service Costing

Service Costing Vs. Product Costing

Unlike products, Composite cost

units are used,

sevices are intangible. for cost measurement.

sevices cannot be stored. to express the volume of outputs.

there are no inventory for the services.

employee (labour) cost constitutes a major cost

element than material cost.

Indirect costs like administration overheads have

significant proportion in total cost.

service sector heavily depends on support services.

WHAT is service cost UNIT?

All the costs incurred during a period are

collected

analyzed

expressed in terms of a cost per unit of service.

LIST of typical cost unit

Service industry Unit of cost (examples)

Transport Services Passenger- km., (In public transportation)
Quintal- km., or Ton- km. (In goods carriage)

Electricity Supply service Kilowatt- hour (kWh)

Hospital Patient per day, room per day or per bed, per
operation, etc.

Canteen Per item, per meal, etc.

Cinema Per ticket

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Service Costing

Hotels Guest Days or Room Days

Bank or Financial Institutions Per transaction, per services (e.g. per letter of credit,
per application, per project, etc.)

Educational Institutes Per course, per student, per batch, per lecture, etc.

Information Technology Enabled Services Cost per project, per module, etc.

Insurance Per policy, per claim, per TPA, etc.

What are the METHODS for ascertaining Service Cost Unit?

Composite Cost Unit

Two measurement units combined together

Example- transportation undertaking measuring operating cost per passenger per kilometre.
Other examples- Ton- km., Quintal- km., Passenger-km., Patient-day etc.

Composite unit may be computed in TWO WAYS

Absolute Commercial
(Weighted Average) basis (Simple Average) basis

Summation of the products Product of average qualitative and total

of qualitative and quantitative factors quantitative factors

+ D2 +
Distance (D)1 + (W × D)2 1
…………...…+ Dn} ×
+…. [(Weight1 + W2 + .... + Wn)/n]
+(W × D)n

Example: A Lorry starts with a load of 20 Metric Ton (MT) of Goods from Station ‘A’. It unloads 8 MT in Station ‘B’
and balance goods in Station ‘C’. On return trip, it reaches Station ‘A’ with a load of 16 MT, loaded at Station ‘C’. The
distance between A to B, B to C and C to A are 80 Kms, 120 Kms and 160 Kms, respectively.

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Service Costing

B
20 Mt – 8 MT = 12 MT
20 MT (120 KM)
(80 KM)
16 MT
A C
(160 KM)

Weighted Average or Absolute basis – MT – Kilometer would be calculated as follows:

= (20 MT × 80 Kms) + (12 MT × 120 Kms) + (16 MT × 160 Kms)
= 1,600 + 1,440 + 2,560 = 5,600 MT – Kilometer
Simple Average or Commercial basis – MT – Kilometer would be calculated as follows:
= [{(20+12+16) / 3} MT × (80 +120 +160) Kms]
= 16 MT × 360 Kms = 5,760 MT – Kilometer

Equivalent Cost Unit/ Equivalent Service Unit

Each grade of service is assigned a weight and converted into equivalent units

Example- hotel having three types of suites for its customers, viz., Standard, Deluxe and Luxurious and
tariff to be decided for one suite being double the rate of other suite.

Example: A hotel may decide tariff to their different type of suites as follows-

Type of suite Number of rooms Room Tariff

Standard 100 Amount X
Deluxe 50 2.5 times of the Standard suites

Luxurious 30 Twice of the Deluxe suites

Since, all three types of suites use same amount of overheads but to attach qualitative weight, these rooms are
required to be converted into equivalent units.

(i) If Standard suite is taken as base:

Nature of suite Occupancy (Room-days) Equivalent single room

suites (Room-days)
Standard 36,000 36,000
(100 rooms x 360 days) (36,000 x 1)

Deluxe 18,000 45,000

(50 rooms x 360 days) (18,000 x 2.5)
Luxurious 10,800 54,000
(30 rooms x 360 days) (10,800 x 5)
1,35,000

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Service Costing

OR

(ii) If Luxurious suite is taken as base:

Nature of suite Occupancy (Room-days) Equivalent luxurious suites(Room-days)

Standard 36,000 7,200
(100 rooms x 360 days) (36,000 x 1/5)

Deluxe 18,000 9,000

(50 rooms x 360 days) (18,000 x ½)

Luxurious 10,800 10,800

(30 rooms x 360 days) (10,800 x 1)

27,000

Statement Of Costs For Service Sectors

Cost sheet on the basis of variability is prepared classifying all the costs into three different heads.

Fixed costs or Standing charges

Variable costs or Operating expenses

Semi-variable costs or Maintenance expenses

Costing Of Transport Services

Types of transport services

Goods transport Passenger transport

Cost unit: Ton– Kilometer Cost unit: Passenger– Kilometre

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Service Costing

Suggestive heads:

• Insurance
• License fees
Standing charges or
• Salary to Driver, Conductor, Cleaners, etc if paid on monthly basis
fixed costs (costs that
remain constant • Garage costs, including garage rent
irrespective of • Depreciation (if related to efflux of time)
distance travelled)
• Taxes
• Administration expenses, etc.

• Petrol and Diesel

Variable costs
• Lubricant oils,
or Running costs
(costs associated • Wages to Driver, Conductor, Cleaners, etc. if it is related to operations
with distance • Depreciation (if related to activity)
travelled)
• Any other variable costs identified.

Semi-variable • Repairs and maintenance

costs or
• Tyres
Maintenance
costs • Spares, etc.

Costing Of Hotels And Lodges

Guest-day
Cost unit or
Room-day

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Costing Of Hospitals

A hospital may have different departments Unit of Cost

such as
• Out - Patient • Out Patient — Per Out-patient

• In Patient • In Patient — Per Room Day

• Medical services like X-Ray, Scanning, etc. • Scanning — Per Case

• General services like Catering, Laundry, Power • Laundry — Per 100 items laundered
house, etc.

• Miscellaneous services like Transport, Dispensary,

etc.

Costing Of Information Technology Enabled Services

EMPLOYEE COST constitutes DIRECT EMPLOYEE COST is

SIGNIFICANT portion of total TRACEABLE to
operating costs. SERVICES RENDERED.

Typical MANPOWER DIRECTLY ENGAGED on a project: SUPPORT MANPOWER ENGAGED on a project:

• Software Engineers / Functional Consultants / • Quality Assurance Team,

Business Analysts,
• Testing team,
• Project Leaders,|
• Version Control team,
• Project Manager,
• Staffing Manager, etc.
• Program Manager, etc.
• If time is NOT TRACEABLE with a single project, then it
• The COSTS are TRACEABLE with a project and hence may either be allocated or apportioned to various
forms part of DIRECT COSTS of the project. projects on some SUITABLE BASIS.

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Service Costing

Costing Of Toll Roads

Entry after
toll tax

• Preliminary and pre-operative expenses,

• Land Acquisition,
Capital Costs
(incurred during
• Materials, Labour, Overheads incurred in the
construction period)
course of actual construction,

• Contingency allowance,
Cost
Involved • Interest during construction period.

Operating and cost of operating tollbooths,

Annual
Maintenance Costs operating
(incurred once the cost administrative expenses,
road is operational)
emergency services,

communications and
security services.

Patching of potholes, sealing

Routine of cracks, edge repair,
maintenance
Surface renewal,

Periodic maintenance.

Total Cost + Profit

To compute the toll rate, following formula may be used: =
Number of Vehicles

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Costing Of Educational Institutions

INCOME of the Educational Institutions

One-time fees like Admission fee, Development fee, Annual fee etc

Recurring fees like tuition fee, laboratory, computer and

internet fee, library fee, training fee, amenities fee, sports fee,
extracurricular activities fee, etc.

Other incomes like transport, hostel, mess and canteen.

EXPENDITURE of the Educational Institutions

Operational Cost like teachers' salary, Building maintenance,

Computer maintenance and internet charges.

Research and Development Cost like academic research on

various fields of specialisations.

Costing Of Insurance Companies

INCOME of Insurance companies

Premium on policy Commission on Fund administration

(periodic or one time) re-insurance fee and return on
investment of funds, etc.

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Service Costing

EXPENDITURE of Insurance companies

Direct costs like commission paid to agents, Indirect costs like

claim settlement, cost of valuation, actuarial fees, market and product
premium for re-insurance, development costs, administration cost,
legal and other costs, etc. asset management cost, etc.

Method of Costing

Activity Based
Costing

Pre-product Post product

development development
activities activities

Market research, Selling of Processing

product policy of claims
development
like specification
of coverage,
conditions, Appointment Claim
amount of of distribution inception,
premium, etc. of sales claim
channel, estimation,
soliciting claim
for policy, settlement
processing of and legal
applications, actions.
etc.

Costing Of Financial Institutions

COSTS TO BE IDENTIFIED with appropriate activities that

have caused its occurrence.

Then costs must be REASSIGNED FROM ACTIVITIES TO

COST OBJECTS based on identified cost drivers.

The concepts on ACTIVITY BASED COSTING under Costing

of Insurance Companies is also applicable to financial
institutions.

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Service Costing

Costing Of Power Houses

Cost per
kilowatthour
Cost unit (kWh)

Suggestive Heads:

Standing charges or Fixed costs Variable costs or Running costs Semi-variable costs or
(costs that remain constant (costs associated with power Maintenance costs
irrespective of power or stream or stream generated)
generated) • Meters
• Fuel Charges
• Rent, Rates & Taxes • Furnaces
• Water Charges
• Insurance • Service materials
• Wages/Labour charges,
• Depreciation if paid on the basis of • Tools, etc.
production
• Salaries, if paid on time
(Monthly basis) • Any other variable costs
identied.
• Administration expenses, etc.

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Standard Costing
Chapter Overview

Meaning of
Standard cost
and Standard
Costing

Advantages Types of
and Criticism Standards
of Standard
Costing

The Process
Computation Standard of Standard
of Variance Costing Costing

Setting-up of
Classification of Standard Cost
Variances

Types of
Standards

What is a Standard or Standard Cost?

Standard cost is defined in the CIMA Official Terminology as “‘the planned unit cost of the product, component or
service produced in a period. The standard cost may be determined on a number of bases. The main use of standard
costs is in performance measurement, control, stock valuation and in the establishment of selling prices.”

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Types of standards
There are various types of standard which are illustrated below:

Ideal Standards: Normal Standards:

The level of performance attainable when These are standards that may be
prices for material and labour are most achieved under normal operating
favourable, when the highest output is conditions.
achieved with the best equipment and
layout and when the maximum efficiency
in utilisation of resources results in
maximum output with minimum cost.

Basic or Bogey Standards: Current Standards:

These standards are used only when they These standards reflect the
are likely to remain constant or unaltered management's anticipation of what
over a long period. actual costs will be for the current period.

Process followed in Standard Costing

Disposition of
Setting of Ascertainment Comparison of Investigate the variances
Standards of actual cost with reasons for
actual costs standard cost variances

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Standard Costing

Variances at a Glance

Total Cost Variance

Material Cost Labour Cost Overhead Cost

Variance Variance Variance

Price Usage Variable Fixed

Rate Idle Time Efficiency
Variance Variance Overheads Overhead
Variance Variance Variance
Variance Variance

Mix Yield Mix Yield Expenditure Efficiency

Variance Variance Variance Variance Variance Variance

Expenditure Volume
Variance Variance

Efficiency Capacity Calendar

Variance Variance Variance

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Variance Analysis
(i) Material Cost Variance
Material Cost Variance
[Standard Cost – Actual Cost]
(The difference between the Standard Material Cost of the actual production volume and
the Actual Cost of Material)
[(SQ × SP) – (AQ × AP)]

Material Price Variance Material Usage Variance

[Standard Cost of Actual Quantity – Actual Cost] [Standard Cost of Standard Quantity for Actual
(The difference between the Standard Price and Actual Production – Standard Cost of Actual Quantity]
Price for the Actual Quantity Purchased) (The difference between the Standard Quantity
[(SP – AP) × AQ] specified for actual production and the Actual
Or Quantity used, at Standard Price)
[(SP × AQ) – (AP × AQ)] [(SQ – AQ) × SP]
Or
[(SQ × SP) – (AQ × SP)]

Material Mix Variance Material Usage Variance

[Standard Cost of Actual Quantity in Standard [Standard Cost of Standard Quantity for Actual
Proportion – Standard Cost of Actual Quantity] Production – Standard Cost of Actual Quantity in
(The difference between the Actual Quantity in Standard Proportion] (The difference between the
standard proportion and Actual Quantity in actual Standard Quantity specified for actual production
proportion, at Standard Price) and Actual Quantity in standard proportion, at
[(RSQ – AQ) × SP] Standard Purchase Price)
Or [(SQ – RSQ) × SP]
[(RSQ × SP) – (AQ × SP)] Or
[(SQ × SP) – (RSQ × SP)]

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Standard Costing

(ii) Labour Cost Variances

Labour Cost Variance

[Standard Cost – Actual Cost]
(The difference between the Standard Labour Cost and the
Actual Labour Cost incurred for the production achieved)
[(SH × SR) – (AH* × AR)]

Labour Rate Variance Labour Idle Time Variance Labour Efficiency Variance

[Standard Cost of Actual Time – [Standard Rate per Hour x Actual [Standard Cost of Standard Time
Actual Cost] Idle Hours] for Actual Production – Standard
Cost of Actual Time]
(The difference between the (The difference between the Actual
Standard Rate per hour and Actual Hours paid and Actual Hours (The difference between the
Rate per hour for the worked at Standard Rate) Standard Hours
Actual Hours paid) specified for actual production and
[(AH* – AH#) × SR] Or Actual Hours worked at Standard
[(SR – AR) × AH*] Or [(AH* × SR) – (AH# × SR)] Rate)
[(SR × AH*) – (AR × AH*)]
[(SH – AH#) × SR] Or
[(SH × SR) – (AH# × SR)]

Labour Mix Variance Or Gang Variance Labour Yield Variance Or Sub-Efficiency Variance

[Standard Cost of Actual Time Worked in Standard [Standard Cost of Standard Time for Actual
Proportion – Standard Cost of Actual Time Worked] Production – Standard Cost of Actual Time Worked in
Standard Proportion]
(The difference between the Actual Hours worked in
standard proportion and Actual Hours worked in (The difference between the Standard Hours specified
actual proportion, at Standard Rate) for actual production and Actual Hours worked in
standard proportion, at Standard Rate)
[(RSH – AH#) × SR] Or
[(RSH × SR) – (AH# × SR)] (SH – RSH) × SR Or
(SH × SR) – (RSH × SR)

(iii) Variable Overhead Variances

Variable Overhead Cost Variance

(Standard Variable Overheads for Production – Actual Variable Overheads)

Variable Overhead Expenditure

(Spending) Variance Variable Overhead Efficiency Variance

(Standard Variable Overheads for Actual Hours#) (Standard Variable Overheads for Production)
Less Less
(Actual Variable Overheads) (Standard Variable Overheads for Actual Hours#)
[(SR – AR) × AH#] [(SH – AH#) × SR]
Or Or
[(SR × AH#) – (AR × AH#)] [(SH × SR) – (AH# × SR)]

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(iv) Fixed Overhead Variances

Fixed Overhead Cost Variance

(Absorbed Fixed Overheads) Less (Actual Fixed Overheads)

Fixed Overhead Expenditure Variance Fixed Overhead Volume Variance

(Budgeted Fixed Overheads) (Absorbed Fixed Overheads)

Less Less
(Actual Fixed Overheads) (Budgeted Fixed Overheads)
Or Or
(BH × SR) – (AH × AR) (SH × SR) – (BH × SR)

Fixed Overhead Capacity Fixed Overhead Calendar Fixed Overhead Efficiency

Variance Variance Variance

SR (AH – BH) Std. Fixed Overhead rate per day SR (AH – SH)
Or (Actual no. of Working days – Or
(AH × SR) – (BH × SR) Budgeted Working days) (AH × SR) – (SH × SR)

AH* - Actual Hours paid

AH# - Actual Hours worked

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Marginal Costing
Chapter Overview

Important Terms
In order to understand the concept of Marginal Costing, let us understand various terms associateed with
Marginal Costing

Marginal Cost as understood in economics is the incremental cost of production which arises due to one-
unit increase in the production quantity.

It is a costing system where products or services and inventories are valued at variable costs only.

Direct Costing and Marginal Costing are used synonymously at various places. But the relation of costs with
respect to activity level must be understood.

Differential Cost is difference between the costs of two different production levels.

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Characteristics of Marginal Costing

Determination of Cost And Profit Under Marginal Costing

For the determination of cost of a product or service under Marginal Costing, costs are classified into variable and
fixed. All the variable costs are part of product and services while fixed costs are charged against contribution margin.

Cost and Profit Statement under Marginal Costing

Amount (R) Amount (R)
Revenue (A) xxx
Product Cost:
- Direct Materials xxx
- Direct employee (labour) xxx
- Direct expenses xxx
- Variable manufacturing overheads xxx
Product (Inventoriable) Costs: (B) xxx xxx
Product Contribution Margin {A – B} xxx
- Variable Administration overheads xxx
- Variable Selling & Distribution overheads xxx xxx
Contribution Margin: (C) xxx
Period Cost: (D)
Fixed Manufacturing expenses xxx
Fixed non-manufacturing expenses xxx xxx
Profit/ (loss) {C – D} xxx

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Advantages and Limitations of Marginal Costing

Advantages of Marginal Costing Limitations of Marginal Costing

• Simplified Pricing Policy • Difficulty in classifying fixed and variable elements
• Proper recovery of Overheads • Dependence on key factors
• Shows Realistic Profit • Scope for Low Profitability
• How much to produce • Faulty valuation
• More control over expenditure • Unpredictable nature of Cost
• Helps in Decision Making • Marginal Costing ignores time factor and investment
• Short term profit planning • Understating of W-I-P

Cost-Volume-Profit (CVP) Analysis

It is a managerial tool showing the relationship between various ingredients of profit planning viz., cost, selling price
and volume of activity

Changes in the levels of revenues

and costs arise only because of
changes in the number of product
(or service) units produced and sold

Do not take into Total costs can be

account the time separated into two
value of money components

Assumptions
Of Cost Volume
Profit (CVP)
Analysis
The proportion of
different products
when multiple The behaviours of
products are sold will total revenues and
remain constant total costs are linear

Selling price, variable cost

per unit, and total fixed costs
(within a relevant range and
time period) are known and
constant

Marginal Cost Equation

Marginal Cost Equation = S -V = C = F ± P

Where,
S = Selling price per unit, V = Variable cost per unit,
C = Contribution, F = Fixed Cost, P = Profit/Loss

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Marginal Cost Statement

(R)
Sales xxxx
Less: Variable Cost xxxx
Contribution xxxx
Less: Fixed Cost xxxx
Profit xxxx

Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio)

This ratio shows the proportion of sales available to cover fixed costs and profit. This ratio is usually expressed in
percentage:

Contribution
P/V Ratio = × 100
Sales or
Change in contribution/ Profit
P/V Ratio = × 100
Change in sales

Breakeven Analysis

Profit
Loss

Breakeven analysis is a generally used method to study the CVP analysis. This technique can be explained in two
ways:
• In narrow sense it is concerned with computing the break-even point.
• In broad sense this technique is used to determine the possible profit/loss at any given level of production or
sales.

Breakeven

Multi-Product Breakeven
Breakeven Point Cash Breakeven point
Analysis

The contribution is calculated by

= Fixed Cost / Contribution per = Cash Fixed Cost /
taking weights (sales quantity/
Unit Contribution per Unit
value) for the products.

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Marginal Costing
? Problem

FERRERO ROCHER is a new entrant in the Indian market for chocolates. It has introduced a new
product— LITTLE JOY. This is a small rectangular chocolate bar. The bars are wrapped in aluminium
foil and packed in attractive cartons containing 50 bars. A carton, is therefore, considered the
basic sales unit. Although management had made detailed estimates of costs and volumes prior
to undertaking this venture, new projections based on actual cost experience are now required.
Income Statements for the last two quarters are each thought to be representative of the costs and
productive efficiency we can expect in the next few quarters. There were virtually no inventories on
hand at the end of each quarter. The income statements reveal the following:–

First Second The firm’s overall marginal and average income tax
Quarter Quarter rate is 40%. This 40% figure has been used to estimate
(R) (R) the tax liability arising from the chocolate operations.
Sales : Required
50,000 × R24 12,00,000 — (i) Management would like to know the breakeven
70,000 × R24 — 16,80,000 point in terms of quarterly carton sales for the
Less: Cost of Goods Sold 7,00,000 8,80,000 chocolates.

Gross Margin 5,00,000 8,00,000 (ii) Management estimates that there is an investment
Less: Selling and of R30,00,000 in this product line. What quarterly
6,50,000 6,90,000 carton sales and total revenue are required in
Administration
each quarter to earn an after-tax return of 20% per
Net Income / (Loss) before
(1,50,000) 1,10,000 annum on investment?
Taxes
Less: Tax (60,000) 44,000 (iii)The firm’s marketing people predict that if the
selling price is reduced by R1.50 per carton (R0.03
Net Income / (Loss) (90,000) 66,000
off per chocolate bar) and a R1,50,000 advertising
campaign among schoolchildren is mounted, sales
will increase by 20% over the second quarter sales.
Should the plan be implemented?

Solution

(i) Estimation of the Fixed and Variable Costs.

Variable Manufacturing Cost per carton:
Change in Costs
=
Change in Activity
R8,80,000-R7,00,000
=
70,000-50,000
`1,80,000
=
20,000
= R9 per carton
Fixed Manufacturing Costs:
Costs of Goods Sold = Fixed Manufacturing Cost + Variable Manufacturing Cost
R7,00,000 = Fixed Manufacturing Cost + (50,000 Cartons × R9)
Fixed Manufacturing Cost = R7,00,000 – R4,50,000
= R2,50,000
Variable Selling and Administration Cost per unit:
R6,90,000-R6,50,000
=
70,000-50,000
(R40,000)
=
20,000

Fixed Selling & Administration Costs: = R2 per unit
Total Selling & Admn. Costs = Fixed Selling & Admn. Cost + Variable Selling & Admn. Costs
R6,50,000 = Fixed Selling & Admn. Costs + (50,000 Cartons × R2)
Fixed Selling & Admn. Cost = R6,50,000 – R1,00,000
= R5,50,000
So the Total Variable Costs per unit are R11 per unit (R9 + R2).
Total Fixed Costs are R8,00,000 per quarter (R2,50,000 + R5,50,000).

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Given Sale Price of R24 per carton and Variable Costs of R11 per carton, the Contribution per carton is R13 (R24 –
R11).
Breakeven Point (in terms of carton units)
Fixed cost (per quarter)
=
Contribution per Carton
= R8,00,000
R13
= 61,539 Cartons
(ii) To earn an After Tax Return of 20% on R30,00,000, the Desired Annual After Tax Net Income is R6,00,000
(R30,00,000 × 20%). The Quarterly After Tax Net Income will be R1,50,000. Given the Tax Rate of 40%, the Pre-tax
Return will be R2,50,000 (R1,50,000 × 100/60).
Fixed Cost + Desired Return
Quarterly Sales (units) = Contribution per unit
R8,00,000 + R2,50,000
=
R13
= R10,50,000
R13
= 80,769 Cartons
Quarterly Sales Revenue = R19,38,456 (80,769 Cartons × R24)

(iii)The proposal involves reducing Selling Price from R24 per carton to R22.50 per carton. Hence the Contribution
per carton will be R11.50 (R22.50 – R11.00).
The increase in Advertising Costs will push Fixed Costs up by R1,50,000 to R9,50,000.
A 20% increase over second quarter’s Sales would increase Sales form 70,000 cartons to 84,000 cartons.
The Expected Earnings Before Taxes will be R16,000 [(84,000 Cartons × R11.50) – R9,50,000].
After deducting Tax at 40%, the Net Income will be R9,600 (R16,000 – R6,400).
Earning has reduced from R66,000 to R9,600, accordingly this plan should not be implemented.

Angle of Incidence

This angle is formed by the intersection of sales line and total cost line at the breakeven point. This angle shows
the rate at which profit is earned once the breakeven point is reached. The wider the angle the greater is the rate
of earning profits. A large angle of incidence with a high margin of safety indicates extremely favourable position.

280

L ine
260
les
Sa
240

220

200
rea
it A
180 of
Pr Line
Cost and Sales (Rs. ‘ 000)

C ost
Margin Angle of Total
160 of incidence
Cost and Sales (` '000)

Safety Break even point

140

120 Variable cost

100

80
ea
Ar
ss
60 Lo

40 Margin
of Fixed cost
20 Safety

0
2 4 6 8 10 12 14 16 18 20 22 24 26 28
B.E.sales Actual sales
Volume of sales (Unit ‘000)

Margin of Safety
MOS is the difference between the expected level of sale and the breakeven sales. The larger is
the margin of safety higher is the profit and vice versa.
Margin of Safety (MOS) = Projected sales – Breakeven sales

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Variations of Basic Marginal Cost Equation and other formulae

i. Sales – Variable cost = Fixed cost ± Profit/ Loss

By multiplying and dividing L.H.S. by S

ii. S(S-V) = F+P

S
iii. S × P/V Ratio = F + P or Contribution (QP/V Ratio = (S-V) )
S

iv BES × P/V Ratio = F (⸪ at BEP profit is zero)

Fixed Cost
v BES =
P/V Ratio

vi P/V Ratio =
Fixed Cost
BES
vii S × P/V Ratio = Contribution (Refer to iii)

viii P/V Ratio = Contribution

Sales
ix (BES + MS) × P/V Ratio = Contribution
(Total sales = BES + MS)

x (BES × P/V Ratio) + (MS × P/V Ratio) = F + P

By deducting (BES × P/V Ratio) from L.H.S. and F from R.H.S. in (x) above, we get:

xi M.S. × P/V Ratio = P

xii P/V Ratio = Change in profit

Change in sales

Change in contribution
xiii P/V Ratio = Change in sales

Contribution
xiv Profitability =
Key factor

Profit
xv Margin of Safety = Total Sales – BES or .
P/V ratio

xvi BES = Total Sales – MS

Margin of Safety Ratio = Total sales - BES
Total sales

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Effect of some independent situations on the P/V ratio

Situation P/V Ratio Reason

An decrease in the physical Will not change The ratio of sales value and variable cost will remain same
sales volume irrespective of change in sales volume.

A increase in the fixed cost Will not change Fixed cost is not considered in calculation of P/V ratio.

A 10% decrease in both selling Will not change The decrease in selling price and variable cost by the same
price and variable cost per unit ratio will not change the P/V ratio.

A 10% increase in the selling Will increase The increase in selling price will increase the contribution
price per unit and 10% decrease margin but the change in sales volume in any direction
in the physical sales volume will not affect P/V ratio. Thus, increase in selling price with
decrease in sales volume will increase the P/V ratio.

A 50% increase in the variable Will decrease The increase in variable cost reduces the contribution
cost per unit and 50% decrease margin thus decreases the PV ratio. Increase or decrease
in the fixed cost in fixed cost will not affect the P/V ratio.

An increase in the angle of Will increase Increase in angle of incidence means increase in rate
incidence of profit earning which is nothing but the P/V ratio that
contributes towards the profitability after recovering the
fixed cost.

Application of CVP Analysis in Decision Making

Decision Making
In traditonal costing methods, total cost is classified as the sum total of the cost of direct material, direct labour, direct
expenses, manufacturing overheads, administration overheads, selling and distribution overheads. In this system, total
cost per unit will remain constant irrespective of the level of output. This causes a problem to the management in
taking sound decisions. Now the management will identify all possible options to answer the problem and to achieve
its goal.

Framework for Decision Making

Identification of
Problem

Selection of the Indentification

Option of Options

Evaluation of
the Options

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Marginal Costing

Analysis of Few Cost and Its Relevance

Abhi Ltd, a company that builds houses presents the following facts relating to a certain housing contract that it wishes
to undertake:
The Marketing person’s food and hotel expenses of R2,400 were incurred for a meeting with a prospective client.
1,000 kg of raw material X will be required for the house. Inventory of X available is 500 kg. It was purchased at R490 per
kg. It is used by Abhi Ltd in other projects. Its current market price is R540 per kg. Its resale value is R310 per kg.
The house will require 100 hours of engineer’s time. The engineers are paid a fixed monthly salary of R55,000 per
engineer who can work 170 hours a month. Spare time is not available now and an engineer has to be hired for this
house for one month. He cannot be used in any other project once he does this contract.
Abhi Ltd will use a special earthquake proof foundation material. This was developed by Abhi Ltd at a cost of R35,000
for some other project that had to be abandoned. If it does not use it in this project, it can use it in some other project
and charge the client R50,000 for it.

Sl. Item Type of Cost Relevant / Irrelevant

No.

1 Food and hotel expenses R2,400 Sunk Cost Irrelevant

2(i) Material X: 500 kg × R490 per kg Historical Cost/Sunk Cost Irrelevant

(ii) Material X: 500 kg × R540 per kg Replacement Cost Relevant

3(i) Engineer’s salary R55,000 Period Cost Relevant

Committed Cost /
(ii) Engineer’s free time cost 70/ 170 × R55,000 Irrelevant
Unavoidable Cost
4(i) Design cost R35,000 Sunk Cost Irrelevant

(ii) Design cost R50,000 Opportunity Cost Relevant

Short-term Decision Making using Concepts of CVP Analysis

Processing of Special Order Make or Buy/ In-house-processing vs Outsourcing

Determination of price for stimulating demand Product mix decision under resource constraints
(limiting factors)
Local vs Export sale

Sales mix decisions

Determination of minimum price for price quotations

Sale or further processing, etc.

Shut-down or continue decision, etc.

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Absorption Costing
Absorption Costing is the practice of charging all costs, both variable and fixed to operations, processes or product. In
Absorption Costing the classification of expenses is based on functional basis and the fixed expenses are distributed
over products on Absorption Costing basis that is, based on a pre-determined level of output. This will lead to over or
under-recovery of expenses since actual output may be greater or lesser than the estimate used for recovery. In this
method, the fixed cost per unit produced decreases with increase in production.

Income Statement (Absorption Costing)

Item (R)
Production Costs: XXXXX
Direct material consumed
Direct labour cost XXXXX
Variable manufacturing overhead XXXXX
Fixed manufacturing overhead XXXXX
Cost of Production XXXXX
Add: Opening stock of finished goods XXXXX
(Value at cost of previous period’s production) XXXXX
Less: Closing stock of finished goods
(Value at production cost of current period) XXXXX
Cost of Goods Sold XXXXX
Add: (or less) Under (or over) absorption of fixed XXXXX
Manufacturing overhead
Add: Administration costs XXXXX
Selling and distribution costs
Total Cost XXXXX XXXXX
Profit (Sales – Total cost) XXXXX XXXXX
XXXXX

Product Mix Decision under Resource Constraints i.e Limiting Factor

Limiting Factor
Limiting Factor is anything that restricts a business from maximizing its sales due to constraints in demand or the
availability of production resources. It may be raw material, machine capacity, regulatory and environmental
requirement, etc. Limiting factor analysis will help business to optimise the key resources up to maximum possible
extent.

Decision Making under CVP Analysis

?
Problem

Elegance Pvt Ltd is considering three possible countries for the sole manufacturing site of leather
purse: Poland, France, and Spain. All leather purses are to be sold to retail outlets for R350 per
unit. These retail outlets add their own markup when selling to the customers. Fixed costs and
variable cost per unit differ in the three countries are given below:

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Country Poland (R) France (R) Spain (R)

Sales Price to Retail Outlets 350 350 350
Annual Fixed Costs 80,00,000 60,00,000 90,00,000
Variable Manufacturing per unit 120 130 110
Variable Marketing & Distribution Cost per unit 25 30 40

Required:
1. Compute the breakeven point in each country in terms of: (a) Units Sold and (b) Sales.
2. If Elegance Pvt Ltd, plans to produce and sell 1,00,000 leather purses in 2024, what is the budgeted operating
income for each of the three countries? Comment on the results.

Solution

Country Poland (R) France (R) Spain (R)

Sales Price to Retail Outlets (1) 350 350 350
Annual Fixed Cost (2) 80,00,000 60,00,000 90,00,000
Variable Manufacturing Cost per Unit (3) 120 130 110
Variable Marketing and Distribution Cost per Unit (4) 25 30 40
Contribution Margin Per Unit (5) = (1) – (3) – (4) 205 190 200
Breakeven Units (6) = (2) ÷ (5) 39,024 31,579 45,000
Breakeven Sales (6) × (1) 1,36,58,537 1,10,52,632 1,57,50,000
Breakeven point in each country in terms of
(a) Units Sold (b) Sales(R)

Poland 39,024 Poland 1,36,58,537

France 31,579 France 1,10,52,632
Spain 45,000 Spain 1,57,50,000
Operating Income for Budgeted Sales of 1,00,000 Units
Items/Country Poland (R) France (R) Spain (R) Total (R)
Contribution Margin Per Unit 205 190 200
Total Contribution for 1,00,000 units 2,05,00,000 1,90,00,000 2,00,00,000
Annual Fixed Cost 80,00,000 60,00,000 90,00,000
Operating Income 1,25,00,000 1,30,00,000 1,10,00,000 3,65,00,000
Comparison of fixed Cost, Contribution Margin, Break-even point, Operating Income at Budgeted sales

Operating income
Country Fixed Cost Contribution Margin Breakeven point
at Budgeted sales
Poland In Between Highest Middle 2nd Best
France Lowest Lowest Lowest Best
Spain Highest In Between Highest Worst

Even though France has the lowest contribution margin per unit, it has the lowest breakeven point as fixed
costs is only R60,00,000. Spain has better contribution margin but has a very high fixed cost. Spain also has
the highest breakeven in terms of sales as well as in units. Fixed costs of Poland are in between Spain and
France, resulting in it to be in the middle in terms of breakeven sales.
Elegance Pvt Ltd should move its production to France because even though it has the lowest contribution
margin per unit, it also has very low (compared to the other countries) fixed costs. At budgeted unit sales of
1,00,000 units, the Company will maximize operating income by producing in France.

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Budget & Budgetary Control

Chapter Overview

Essentials of
Budget

Objectives of
Budgeting
Capacity-wise

Types of
Budgets
Budget &
Budgetary Control Functions-wise
Zero-based
Budgeting (ZBB)
Period-wise

Performance
Budgeting
Master Budget

Budget Ratio

Definition and Terminology

Let us first define various important terminologies used in budget and budgetary control.

Budget Budgeting Budgetary control

Quantitative expression of a plan Coordinating the combined The establishment of budgets

for a defined period of time intelligence of an entire relating to theresponsibilities of
organisation into a plan of action executives of a policy and the
based on past performance continuous comparison of the
actual with the budgeted results,
either to secure by individual
action the objective of the policy
or to provide a basis for its
revision

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Essentials of Budget
Essential elements of budget are illustrated below:

Essential elements of a budget

Organisational Setting of clear Budgets are Budgets are Budgets should Budgetary
structure must objectives and prepared for updated for the be quantifiable performance
be clearly reasonable the future events that were and master needs to be
defined targets periods based not kept into budget should linked
on expected the mind while be broken effectively to the
course establishing down into reward system
of actions budgets various
functional
budgets.
Budgets should
be
monitored
periodically

Characteristics of Budget
Main characteristics of budget are as below:

It is concerned
for a definite
future period
It is a written
Budget is usually document
prepared in the light
of past experiences
Characteristics
of a Budget
It is a detailed
Budget helps plan of all
in planning, the economic
coordination activities of a
and control business
Budget is a
means to
achieve
business and it
is not an end in
itself

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Advantages of Budgetary Control System

There are many advantages of budgetary control system, and some of the them are illustrated below:

Control on
expenditure

Credit Rating Efficiency

Advantages
Cost of Budgetary Finding
Consciousness Control deviations
System

Implementation Effective
of Standard utilisation
Costing system of
resources
Revision of
plans

Classification of Budget
BUDGET

Capacity wise Functions wise Master Budget Period wise

• Sales budget
• Production budget
Flexible • Plant utilisation budget Long-term Short-term Current
Fixed Budget
Budget • Direct-material usage budget Budgets Budgets Budgets
• Direct-material purchase budget
• Direct-labour (personnel) budget
• Factory overhead budget
• Production cost budget
• Ending-inventory budget
• Cost of goods-sold budget
• Selling and distribution cost budget
• Administration expenses budget
• Research and development cost budget
• Capital expenditure budget
• Cash budget

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Objectives of Budgeting
The objectives of budgeting begin with planning and ends with controlling. Once the planning is done, they can be
used for directing and controlling operations so that the stated targets in planning are achieved.

Directing
Planning Controlling and
Coordinating

Definition of different types of Budget

Functional Budgets Budgets which relate to the individual functions in an organisation are known as Functional
Budgets. For example, purchase budget; sales budget; production budget; plant-utilisation
budget and cash budget.
Master Budget It is a consolidated summary of the various functional budgets. It serves as the basis upon
which budgeted P & L A/c and forecasted Balance Sheet are built up.
Long-term Budgets The budgets which are prepared for periods longer than a year are called long-term
budgets. Such budgets are helpful in business forecasting and forward planning. Capital
expenditure budget and Research and Development budget are examples of long-term
budgets.
Short-term Budgets Budgets which are prepared for periods less than a year are known as short-term budgets.
Cash budget is an example of short-term budget. Such types of budgets are prepared in
cases where a specific action has to be immediately taken to bring any variation under
control, as in cash budgets.
Basic Budgets A budget which remains unaltered over a long period of time is called basic budget.
Current Budgets A budget which is established for use over a short period of time and is related to the
current conditions is called current budget.
Fixed Budget According to CIMA official terminology, “a fixed budget, is a budget designed to remain
unchanged irrespective of the level of activity actually attained”.
Flexible Budget According to CIMA official terminology, “a flexible budget is defined as a budget which,
by recognizing the difference between fixed, semi-variable and variable costs is designed to
change in relation to the level of activity attained.”

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Differences between Fixed Budget and Flexible Budget

Sl. Fixed Budget Flexible Budget
no.

1. It does not change with actual volume of activity It can be re-casted on the basis of activity level to
achieved. Thus it is known as rigid or inflexible budget be achieved. Thus it is not rigid.

2. It operates on one level of activity and under one set of con- It consists of various budgets for different levels
ditions. It assumes that there will be no change in the pre- of activity.
vailing conditions, which is unrealistic.

3. Here as all costs like - fixed, variable and semi-variable are Here, analysis of variance provides useful infor-
related to only one level of activity, so variance analysis does mation as each cost is analysed according to its
not give useful information. behaviour.

4. If the budgeted and actual activity levels differ significantly, Flexible budgeting at different levels of activity fa-
then the aspects like cost ascertainment and price fixation cilitates the ascertainment of cost, fixation of sell-
do not give a correct picture. ing price and tendering of quotations.

5. Comparison of actual performance with budgeted targets It provides a meaningful basis of comparison
will be meaningless specially when there is a difference be- of the actual performance with the budgeted
tween the two activity levels. targets.

Zero-Based Budgeting (ZBB)

It is defined as ‘a method of budgeting which requires each cost element to be specifically justified, although the
activities to which the budget relates are being undertaken for the first time, without approval, the budget allowance
is zero’.

Stages in Zero-based budgeting

Identification and description of Decision packages

Evaluation of Decision packages

Ranking (Prioritisation) of the Decision packages

Allocation of resources

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Performance Budgeting
A performance budget is one which presents the purposes and objectives for which funds are required, the costs of the
programmes proposed for achieving those objectives, and quantitative data measuring the accomplishments and
work performed under each programme.

Steps in Performance Budgeting

Evolving suitable norms,

Establishing a
yardsticks, work units of
meaningful Bringing the system of
performance and units
functional programme accounting and
costs, wherever possible
and activity financial
under each programme
classification management in accord
and activity for their
of government with this classification
reporting and
operations
evaluation

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NOTES

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NOTES

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NOTES

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